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Managerial Economics and Organizational Architecture
The McGraw-Hill Series in Economics
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Managerial Economics and Organizational Architecture Sixth Edition
JAMES A. BRICKLEY
CLIFFORD W. SMITH
JEROLD L. ZIMMERMAN
William E. Simon Graduate School of Business Administration
University of Rochester
MANAGERIAL ECONOMICS AND ORGANIZATIONAL ARCHITECTURE, SIXTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2009, 2007, and 2004. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
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Library of Congress Cataloging-in-Publication Data
Brickley, James A. Managerial economics and organizational architecture / James A. Brickley, Clifford
W. Smith, Jerold L. Zimmerman, William E. Simon, Graduate School of Business Administration, University of Rochester.—Sixth edition.
pages cm.—(The McGraw-Hill series in economics) ISBN 978-0-07-352314-9 (alk. paper)
1. Managerial economics. 2. Organizational effectiveness. I. Title. HD30.22.B729 2015 658—dc23
2014043202
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.
Dedicated to our children— London, Nic, Alexander, Taylor, Morgan, Daneille, and Amy.
PREFACE The past few decades have witnessed spectacular business failures and scandals. In 2001 and 2002, Enron, WorldCom, Arthur Andersen, as well as other prominent com- panies imploded in dramatic fashion. Internationally, scandals emerged at companies such as Parmalat, Royal Dutch Shell, Samsung, and Royal Ahold. In 2007 and 2008, prominent financial institutions around the world shocked financial markets by reporting staggering losses from subprime mortgages. Société Générale, the large French bank, reported over $7 billion in losses due to potentially fraudulent securities trading by one of its traders. JPMorgan Chase bailed out Bear Stearns, a top-tier in- vestment bank, following their massive subprime losses. Washington Mutual and Lehman Brothers were added to the list of “top business failures of all time.”
Due to these cases and others, executives now face a more skeptical investment community, additional government regulations, and stiffer penalties for misleading public disclosures. A common perception is that bad people caused many of these problems. Others argue that the sheer complexity of today’s world has made it virtu- ally impossible to be a “good” manager. These views have raised the cry for in- creased government regulation, which is argued to be a necessary step in averting fu- ture business problems.
We disagree with this view. We suggest that many business problems result from poorly structured organizational architectures. The blueprints for many of these prominent business scandals were designed into the firms’ “organizational DNA.” This book, in addition to covering traditional managerial economic topics, examines how firms can structure organizations that channel managers’ incentives into actions that create, rather than destroy, firm value. This topic is critical to anyone who works in or seeks to manage organizations—whether for-profit or not-for-profit.
New Demands: Relevant Yet Rigorous Education Thirty years ago, teaching managerial economics to business students was truly a “dis- mal science.” Many students dismissed standard economic tools of marginal analysis, production theory, and market structure as too esoteric to have any real relevance to the business problems they anticipated encountering. Few students expected they would be responsible for their prospective employers’ pricing decisions. Most sought positions in large firms, eventually hoping to manage finance, operations, marketing, or information systems staffs. Traditional managerial economics courses offered few insights that obviously were relevant for such careers. But a new generation of economists began applying traditional economic tools to problems involving corporate governance, merg- ers and acquisitions, incentive conflicts, and executive compensation. Their analysis fo- cused on the internal structure of the firm—not on the firm’s external markets. In this book, we draw heavily from this research and apply it to how organizations can create value through improved organizational design. In addition, we present traditional economic topics—such as demand, supply, markets, and strategy—in a manner that emphasizes their managerial relevance within today’s business environment.
Today’s students must understand more than just how markets work and the prin- ciples of supply and demand. They also must understand how self-interested parties within organizations interact, and how corporate governance mechanisms can control these interactions. Consequently, today’s managerial economics course must cover a broader menu of topics that are now more relevant than ever to aspiring managers facing this post-Enron world. Yet, to best serve our students, offering
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Preface vii
relevant material must not come at the expense of rigor. Students must learn how to think logically about both markets and organizations. The basic tools of economics offer students the skill set necessary for rigorous analysis of business problems they likely will encounter throughout their careers.
Besides the heightened interest in corporate governance, global competition and rapid technological change are prompting firms to undertake major organizational restructurings as well as to produce fundamental industry realignments. Firms now attack problems with focused, cross-functional teams. Many firms are shifting from functional organizational structures (manufacturing, marketing, and distribution) to flatter, more process-oriented organizations organized around product or region. Moreover, this pace of change shows no sign of slowing. Today’s students recognize these issues; they want to develop skills that will make them effective executives and prepare them to manage organizational change.
Business school programs are evolving in response to these changes. Narrow tech- nical expertise within a single functional area—whether operations, accounting, fi- nance, information systems, or marketing—is no longer sufficient. Effective man- agers within this environment require cross-functional skills. To meet these challenges, business schools are becoming more integrated. Problems faced by man- agers are not just finance problems, operations problems, or marketing problems. Rather, most business problems involve facets that cut across traditional functional areas. For that reason, the curriculum must encourage students to apply concepts they have mastered across a variety of courses.
This book provides a multidisciplinary, cross-functional approach to managerial and organizational economics. We believe that this is its critical strength. Our interests span economics, finance, accounting, information systems, and financial in- stitutions; this allows us to draw examples from a number of functional areas to demonstrate the power of this underlying economic framework to analyze a variety of problems managers face regularly.
We have been extremely gratified by the reception afforded the first five editions of Managerial Economics and Organizational Architecture. Adopters report that the earlier editions helped them transform their courses into one of the most popular courses within their curriculum. This book has been adopted in microeconomics, human resources, and strategy courses in addition to courses that focus specifically on organizational economics. The prior editions were founded on powerful economic tools of analysis that examine how managers can design organizations that motivate self-interested individuals to make choices that increase firm value. Our sixth edition continues to focus on the fundamental importance of markets and organizational de- sign. We use the failures of Enron (Chapter 1), Société Générale (Chapter 1), Arthur Andersen (Chapter 22), and Adelphia (Chapter 10) as case studies to illustrate how poorly designed organizational architectures can be catastrophic. Other books provide little coverage of such managerially critical topics as developing effective organiza- tional architectures, including performance-evaluation systems and compensation plans; assigning decision-making authority among employees; and managing transfer- pricing disputes among divisions. Given the increased importance of corporate gover- nance, this omission has been both significant and problematic. Our primary objective in writing this book is to provide current and aspiring managers with a rigorous, sys- tematic, comprehensive framework for addressing such organizational problems. To that end, we have endeavored to write the underlying theoretical concepts in simple, intuitive terms and illustrate them with numerous examples—most drawn from actual company practice.
viii Preface
The Conceptual Framework Although the popular press and existing literature on organizations are replete with jargon—TQM, reengineering, outsourcing, teaming, venturing, empowerment, and cor- porate culture—they fail to provide managers with a systematic, comprehensive frame- work for examining organizational problems. This book uses economic analysis to develop such a framework and then employs that framework to organize and integrate the important organizational problems, thereby making the topics more accessible.
Throughout the text, readers will gain an understanding of the basic tools of eco- nomics and how to apply them to solve important business problems. While the book covers the standard managerial economics problems of pricing and production, it pays special attention to organizational issues. In particular, the book will help read- ers understand:
• How the business environment (technology, regulation, and competition in input and output markets) drives the firm’s choice of strategy.
• How strategy and the business environment affect the firm’s choice of organi- zational design—what we call organizational architecture.
• How the firm’s organizational architecture is like its DNA; it plays a key role in determining a firm’s ultimate success or failure, since it affects how people in the organization will behave in terms of creating or destroying firm value.
• How corporate policies such as strategy, financing, accounting, marketing, in- formation systems, operations, compensation, and human resources are inter- related and thus why it is critically important that they be coordinated.
• How the three key features of organizational architecture—the assignment of decision-making authority, the reward system, and the performance-evaluation
system—can be structured to help managers to achieve their desired results.
These three components of or- ganizational architecture are like three legs of the accompanying stool. Firms must coordinate each leg with the other two so that the stool remains functional. More- over, each firm’s architecture must match its strategy; a balanced stool in the wrong setting is dysfunc- tional: Although milking stools are quite productive in a barn, tavern owners purchase taller stools.
Reasons for Adopting Our Approach This book focuses on topics that we believe are most relevant to managers. For in- stance, it provides an in-depth treatment of traditional microeconomic topics (demand, supply, pricing, and game theory) in addition to corporate governance topics (assign- ing decision-making authority, centralization versus decentralization, measuring and
The components of organizational architecture are like three legs of a stool. It is important that all three legs be designed so that the stool is balanced. Changing one leg without the careful consideration of the other two is typically a mistake.
Performance Evaluation (What are the key performance measures
used to evaluate managers and employees?)
Rewards (How are people rewarded for meeting performance goals?)
Decision-Rights Assignment (Who gets to make what decisions?)
Preface ix
rewarding performance, outsourcing, and transfer pricing). We believe these topics are more valuable to prospective managers than topics typically covered in economics texts such as public-policy aspects of minimum-wage legislation, antitrust policy, and income redistribution. A number of other important features differentiate this book from others currently available, such as:
• Our book provides a comprehensive, cross-functional framework for analyzing organizational problems. We do this by first describing and integrating important research findings published across several functional areas, then demonstrating how to apply the framework to specific organizational problems.
• This text integrates the topics of strategy and organizational architecture. Students learn how elements of the business environment (technology, compe- tition, and regulation) drive the firm’s choice of strategy as well as the interaction of strategy choice and organizational architecture.
• Reviewers, instructors, and students found the prior editions accessible and engaging. The text uses intuitive descriptions and simple examples; more technical material is provided in appendices for those who wish to pursue it.
• Numerous examples drawn from the business press and our experiences illus- trate the theoretical concepts. For example, the effect of the 9/11 terrorist attacks on demand curves is described in Chapter 4 and how one devastated company located in the World Trade Center responded is discussed in Chapter 14. These illustrations, many highlighted in boxes, reinforce the underlying principles and help the reader visualize the application of more abstract ideas. Each chapter begins with a specific case history that is used throughout the chapter to unify the material and aid the reader in recalling and applying the main constructs.
• Nontraditional economics topics dealing with strategy, outsourcing, leader- ship, organizational form, corporate ethics, and the implementation of man- agement innovations are examined. Business school curricula often are criti- cized for being slow in covering topics of current interest to business, such as corporate governance. The last six chapters examine recent management trends and demonstrate how the book’s framework can be used to analyze and understand topical issues.
• Problems, both within and at the end of chapter, are drawn from real organiza- tional experience—from the business press as well as our contact with execu- tive MBA students and consulting engagements. We have structured exercises that provide readers with a broad array of opportunities to apply the framework to problems like ones they will encounter as managers.
Organization of the Book • Part 1: Basic Concepts lays the groundwork for the book. Chapter 2 summa-
rizes the economic view of behavior, stressing its management implications. Chapter 3 presents an overview of markets, provides a rationale for the exis- tence of organizations, and stresses the critical role of the distribution of knowledge within the organization.
• Part 2: Managerial Economics applies the basic tools of economic theory to the firm. Chapters 4 through 7 cover the traditional managerial-economics top- ics of demand, production and cost, market structure, and pricing. These four chapters provide the reader with a fundamental set of microeconomic tools and
use these tools to analyze basic operational policies such as input, output, and product pricing decisions. Chapters 8 and 9 focus on corporate strategy—the former on creating and capturing values and the latter on employing game the- ory methods to examine the interaction between the firm and its competitors, suppliers, as well as other parties. These chapters also provide important background material for the subsequent chapters on organizations: A robust understanding of the market environment is important for making sound orga- nizational decisions. Chapter 10 examines conflicts of interest that exist within firms and how contracts can be structured to reduce or control these conflicts.
• Part 3: Designing Organizational Architecture develops the core frame- work of the book. Chapter 11 provides a basic overview of the organiza- tional-design problem. Chapters 12 and 13 focus on two aspects of the as- signment of decision rights within the firm—the level of decentralization chosen for various decisions followed by the bundling of various tasks into jobs and then jobs into subunits. Chapters 14 and 15 examine compensation policy. First we focus on the level of compensation necessary to attract and retain an appropriate group of employees. We then discuss the composition of the compensation package, examining how the mix of salary, fringe ben- efits, and incentive compensation affects the value of the firm. In Chapters 16 and 17, we analyze individual and divisional performance evaluation. Part 3 concludes with a capstone case on Arthur Andersen.
• Part 4: Applications of Organizational Architecture uses the framework that we have developed to provide insights into contemporary management is- sues. Chapters 18 through 23 discuss the legal form of organization, outsourc- ing, leadership, regulation, ethics, and management innovations.
Fitting the Text into the Business Curriculum Our book is an effective tool for a variety of classes at the MBA, executive MBA, and undergraduate level. Although this text grew out of an MBA elective course in the eco- nomics of organizations at the University of Rochester, the book’s modular design al- lows its use in a variety of courses. We have been encouraged by the creativity instruc- tors have shown in the diversity of courses adopting this text. Besides the introductory microeconomics course, this book also is used in elective courses on corporate gover- nance, strategy, the economics of organizations, and human resources management. The basic material on managerial economics is presented in the first 10 chapters. The tools necessary for understanding and applying the organizational framework we de- velop within this text have been selected for their managerial relevance. In our experi- ence, these economics tools are invaluable for those students with extensive work experience, and for those who didn’t major in economics as an undergraduate. Those with an economics background may choose to forgo components of this material. We have structured our discussions of demand, production/cost, market structure, pricing, and strategy to be optional. Thus, readers who do not require a review of these tools can skip Chapters 4 through 9 without loss of continuity.
We strongly recommend that all readers cover Chapters 1 through 3 and 10; these chapters introduce the underlying tools and framework for the text. Chapters 4 through 9, as we noted above, cover the basic managerial-economics topics of demand, costs, production, market structure, pricing, and strategy. Chapters 11 through 17 develop the organizational architecture framework; we recommend that these be covered in
x Preface
sequence. Finally, Chapters 18 through 23 cover special managerial topics: outsourc- ing, leadership, regulation, ethics, and the process of management innovation and man- aging organizational change. They are capstone chapters—chapters that apply and il- lustrate the framework. Instructors can assign them based on their specific interests and available time.
Sixth Edition This book is noted for using economics to analyze real-world management problems. The sixth edition maintains and extends this focus. Changes from the fifth edition include:
• Learning objectives have been added to focus on the core concepts of the chap- ter to aid in the assessment of learning outcomes.
• Extended and more in-depth coverage of important managerial economics concepts, including supply and demand analysis, comparative advantage, con- stant versus increasing cost industries, price competition with differentiated products, inter-temporal decisions (Fisher Separation Theorem) and behav- ioral economics.
• Managerial applications, examples, exhibits, and other boxed materials have been updated.
• Key managerial insights from important recent research in organizational economics have been added.
• Data has been updated, where appropriate.
• We have responded in various ways to reader feedback from earlier editions.
Supplements The following ancillaries are available for quick download and convenient access via the Instructor Library material available through McGraw-Hill Connect®.
• PowerPoint Presentations: Fully updated for the sixth edition, each chapter’s PowerPoint slides are closely tied to the book material and are enhanced by animated graphs. You can edit, print, or rearrange the slides to fit the needs of your course.
• Test Bank: The test bank offers hundreds of questions categorized by level of difficulty, AACSB learning categories, Bloom’s taxonomy, and topic.
• Computerized Test Bank: McGraw-Hill’s EZ Test is a flexible and easy-to- use electronic resting program that allows you to create tests from book- specific items. It accommodates a wide range of question types and you can add your own questions. Multiple versions of the test can be created and any test can be exported for use with course management systems. EZ Test Online gives you a place to administer your EZ Test-created exams and quizzes online. Addition- ally, you can access the test bank through McGraw-Hill Connect®.
• Instructor’s Manual: The instructor’s Manual provides chapter overviews, teaching tips, and suggested answers to the end-of-chapter Self-Evaluation Problems and Review Questions.
Preface xi
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xii Preface
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Preface xiii
xiv
ACKNOWLEDGMENTS No textbook springs from virgin soil. This book has its intellectual roots firmly planted in the work of dozens who have toiled to develop, test, and apply organiza- tion theory. As we detailed in the preface to the first edition, the genesis of this book was a course William Meckling and Michael Jensen taught on the economics of or- ganizations at the University of Rochester in the 1970s. Bill’s and Mike’s research and teaching stimulated our interest in the economics of organizations, prompted much of our research focused on organizational issues, and had a profound effect on this text. No amount of citation or acknowledgments can adequately reflect the encouragement and stimulation that they provided, both personally and through their writings.
Bill and Mike emphasized three critical features of organizational design: (1) the assignment of decision rights within the organization, (2) the reward system, and (3) the performance-evaluation system. These three elements, which we call organi- zational architecture, serve as an important organizing device for this book. As read- ers will discover, this structure offers a rich body of knowledge useful for managerial decision making.
Important contributions to the literature on the economics of organizations have been made by a host of scholars. Through the work of these individuals, we have learned a tremendous amount. A number of our colleagues at Rochester also con- tributed to the development of the book. Ray Ball, Rajiv Dewan, Shane Heitzman, Scott Keating, Stacey Kole, Andy Leone, Glenn MacDonald, Larry Matteson, David Mayers, Kevin Murphy, Michael Raith, Mike Ryall, Greg Schaffer, Ronald Schmidt, Larry Van Horn, Karen Van Nuys, Ross Watts, Gerald Wedig, Michael Weisbach, and Ron Yeaple offered thoughtful comments and suggestions that helped to clarify our thinking on key issues. Don Chew, editor of the Journal of Applied Corporate Fi- nance, provided invaluable assistance in publishing a series of articles based on the book; his assistance in writing these articles improved the exposition of this book enormously. Our collaboration with Janice Willett on Designing Organizations to Create Value: From Strategy to Structure (McGraw-Hill, 2003) enriched our under- standing and exposition of many important topics.
This project also has benefited from an extensive development effort. In addition to generations of Simon School students, dozens of colleagues both in the United States and overseas formally reviewed the manuscript and gave us detailed feedback, for which we are very grateful. We offer our sincere thanks to following reviewers, for their thorough and thoughtful suggestions:
Avner Ben-Ner, University of Minnesota Arnab Biswas, University of West Florida Ben Campbell, The Ohio State University Xiujian Chen, Binghampton University Kwang Soo Cheong, John Hopkins University Abbas Grammy, California State University—Bakersfield Charles Gray, University of Saint Thomas Folke Kafka, University of Pittsburgh Brian Kench, University of Tampa Tom Lee, California State University—Northridge Matthew Metzgar, University of North Carolina Ronald Necoechea, Roberts Wesleyan College Harlan Platt, Northeastern University
Acknowledgments xv
Farhad Rassekh, University of Hartford Amit Sen, Xavier University Richard Smith, University of California—Riverside Neil Younkin, Saint Xavier University
We owe special thanks to Henry Butler, Luke Froeb, Mel Gray, and Chris James; each provided insightful comments on the material. In addition, we are grateful for feedback from over 500 individuals who completed various surveys. Their thoughts served to guide our refinement of this work. We appreciate the efforts of Kathleen DeFazio who provided secretarial support. Finally, we wish to thank our colleagues at McGraw-Hill/Irwin—especially Mike Junior—for their encouragement to pursue this project. Through their vision and publishing expertise, they provided us with insights and feedback to help expand our audience while adhering to our mission.
This book represents the current state of the art. Nonetheless, development is on- going as the research evolves and as we continue to learn. Managerial Economics and Organizational Architecture covers an exciting, dynamic area. We hope that a small portion of that excitement is communicated through this text. Reviewers, instructors, and students frequently mention the relevance of material to the business community, the accessibility of the text, and the logical flow within the text’s framework. However, in the final analysis, it is instructors and their students who will determine the true value of our efforts.
We appreciate the extensive feedback we have received from many readers; their generous comments have improved this edition substantially. Although we had a def- inite objective in mind as we wrote this book, it is important to be open to sugges- tions and willing to learn from others who are traveling a similar yet distinct path. Al- though we are unlikely to please everyone, we will continue to evaluate suggestions critically and to be responsive where consistent with our mission. If readers would like to share their thoughts on this work or their classroom experiences, please feel free to contact any of us at the University of Rochester. Many thanks in advance for the assistance.
[email protected] [email protected]
xvi
Contents in Brief
Part 1: Basic Concepts
Chapter 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 2 Economists’ View of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Chapter 3 Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Part 2: Managerial Economics
Chapter 4 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Chapter 5 Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Chapter 6 Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Chapter 7 Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Chapter 8 Economics of Strategy: Creating and Capturing Value . . . . . . . . . . 257 Chapter 9 Economics of Strategy: Game Theory . . . . . . . . . . . . . . . . . . . . . . . 296 Chapter 10 Incentive Conflicts and Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 329
Part 3: Designing Organizational Architecture
Chapter 11 Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 Chapter 12 Decision Rights: The Level of Empowerment . . . . . . . . . . . . . . . . . 376 Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . 410 Chapter 14 Attracting and Retaining Qualified Employees . . . . . . . . . . . . . . . . 438 Chapter 15 Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469 Chapter 16 Individual Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 502 Chapter 17 Divisional Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 537
Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
Part 4: Applications of Organizational Architecture
Chapter 18 Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578 Chapter 19 Vertical Integration and Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . 615 Chapter 20* Leadership: Motivating Change within Organizations . . . . . . . . . . . 654 Chapter 21 Understanding the Business Environment:
The Economics of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655 Chapter 22 Ethics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 684 Chapter 23* Organizational Architecture and the Process
of Management Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714
Index 715
Glossary* G-1
*These Web chapters and the Glossary can be found online via the Instructor Library material available through
McGraw-Hill Connect®.
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Contents
Part 1: Basic Concepts Chapter 1: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Managerial Economics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 3
Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4
Economic Darwinism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Survival of the Fittest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Economic Darwinism and Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Purpose of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Our Approach to Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10
Chapter 2: Economists’ View of Behavior . . . . . . . . . . . . . . . . . . . . .14 Economic Behavior: An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
Economic Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Creativity of Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
Graphical Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Individual Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Indifference Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Opportunities and Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Individual Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Changes in Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Motivating Honesty at Merrill Lynch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Alternative Models of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Only-Money-Matters Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Happy-Is-Productive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Good-Citizen Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Product-of-the-Environment Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Which Model Should Managers Use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Decision Making under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Expected Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Variability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Certainly Equivalent and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Risk Aversion and Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Appendix A: Consumer Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem . . . . . . 61
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Chapter 3: Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . 66 Goals of Economic Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Property Rights and Exchange in a Market Economy . . . . . . . . . . . . . . . . . . . . . . . 68
Dimensions of Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Basics of Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 The Price Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Shifts in Curves versus Movements along Curves . . . . . . . . . . . . . . . . . . . . . .79 Using Supply and Demand Analysis for Qualitative Forecasts . . . . . . . . . . . .79 Linear Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Supply and Demand—Extended Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Price versus Quantity Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Short-Run versus Long-Run Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84 Industry Cost Increases and Price Adjustments . . . . . . . . . . . . . . . . . . . . . . . .86
Prices as Social Coordinators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Efficient Exchange and Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 Measuring the Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Externalities and the Coase Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Markets versus Central Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 General versus Specific Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Knowledge Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 Specific Knowledge and the Economic System . . . . . . . . . . . . . . . . . . . . . . 102 Incentives in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Contracting Costs and Existence of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Contracting Costs in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Contracting Costs within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Managerial Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Appendix: Shareholder Value and Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . 114
Part 2: Managerial Economics Chapter 4: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Demand Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Law of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Elasticity of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Linear Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Other Factors That Influence Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Prices of Related Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Other Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Industry versus Firm Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Network Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Product Attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Product Life Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Demand Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Interviews . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Price Experimentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142
Statistical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Appendix: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Chapter 5: Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Production Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Returns to Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .158 Returns to a Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159
Choice of Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Production Isoquants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Isocost Lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .164 Cost Minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165 Changes in Input Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167
Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168 Cost Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169 Short Run versus Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .171 Minimum Efficient Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175 Learning Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177 Economies of Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178
Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Factor Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .180 Cost Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .184 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .185 Appendix: The Factor-Balance Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .191
Chapter 6: Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195
Firm Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .198
Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 Incumbent Reactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .202 Incumbent Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .203 Exit Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204
Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .206 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208
Nash Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208 Output Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .210 Price Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213 Cooperation and the Prisoners’ Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . .214
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217
Chapter 7: Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . 223 Pricing Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .224 Benchmark Case: Single Price per Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225
Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225 Estimating the Profit-Maximizing Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . .228 Potential for Higher Profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231
Contents xix
Homogeneous Consumer Demands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Block Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Two-Part Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .233
Price Discrimination—Heterogeneous Consumer Demands . . . . . . . . . . . . . . . . . .234 Exploiting Information about Individual Demands . . . . . . . . . . . . . . . . . . . .236 Using Information about the Distribution of Demands . . . . . . . . . . . . . . . . .239
Bundling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .242 Other Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244
Multiperiod Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244 Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246 Legal Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247
Implementing a Pricing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .248 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250
Chapter 8: Economics of Strategy: Creating and Capturing Value . . . . . . . . . . . . . . . . . . . . .257
Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .258 Value Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .259
Production and Producer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . .261 Consumer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261 Other Ways to Increase Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262 New Products and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Cooperating to Increase Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Converting Organizational Knowledge into Value . . . . . . . . . . . . . . . . . . . . .266 Opportunities to Create Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267
Capturing Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .270 Superior Factors of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273 A Partial Explanation for Walmart’s Success . . . . . . . . . . . . . . . . . . . . . . . . .278 All Good Things Must End . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Economics of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Benefits of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Costs of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284
Strategy Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding Resources and Capabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Combining Environmental and Internal Analyses . . . . . . . . . . . . . . . . . . . . .287 Strategy and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .288 Can All Firms Capture Value? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Chapter 9: Economics of Strategy: Game Theory . . . . . . . . . . . . . . 296 Game Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297 Simultaneous-Move, Nonrepeated Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299
Analyzing the Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Dominant Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .300 Nash Equilibrium Revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301 Competition versus Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303 Mixed Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .306 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .308
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Sequential Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310 First-Mover Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Strategic Moves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .313
Repeated Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .314 Strategic Interaction and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .316 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .318 Appendix: Repeated Interaction and the Teammates’ Dilemma . . . . . . . . . . . . . . .323
Chapter 10: Incentive Conflicts and Contracts . . . . . . . . . . . . . . . 329 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330 Incentive Conflicts within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332
Owner-Manager Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332 Other Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .334
Controlling Incentive Problems through Contracts . . . . . . . . . . . . . . . . . . . . . . . . .334 Costless Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335 Costly Contracting and Asymmetric Information . . . . . . . . . . . . . . . . . . . . . .338 Postcontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340 Precontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343
Implicit Contracts and Reputational Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . .347 Incentives to Economize on Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .349 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350
Part 3: Designing Organizational Architecture
Chapter 11: Organizational Architecture . . . . . . . . . . . . . . . . . . . . 355 The Fundamental Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357
Architecture of Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357 Architecture within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Architectural Determinants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .360 Changing Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364 Interdependencies and Complementarities within the Organization . . . . . . .365
Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366 When Management Chooses an Inappropriate Architecture . . . . . . . . . . . . . . . . . .370 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371
Evaluating Management Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .373
Chapter 12: Decision Rights: The Level of Empowerment . . . . . . . 376 Assigning Tasks and Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378 Centralization versus Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380
Benefits of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380 Costs of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382 Illustrating the Trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .385 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .389
Lateral Decision-Right Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393
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Assigning Decision Rights to Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Benefits of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Costs of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395
Decision Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .397 Decision-Right Assignment and Knowledge Creation . . . . . . . . . . . . . . . . . . . . . .399 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403 Appendix: Collective Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .407
Chapter 13: Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . . . . . . . . . . . .410
Bundling Tasks into Jobs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411 Specialized versus Broad Task Assignment . . . . . . . . . . . . . . . . . . . . . . . . . .411 Productive Bundling of Tasks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .415
Bundling of Jobs into Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416 Grouping Jobs by Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .417 Grouping Jobs by Product or Geography . . . . . . . . . . . . . . . . . . . . . . . . . . . .419 Trade-offs between Functional and Product or Geographic Subunits . . . . . .420 Environment, Strategy, and Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .423 Matrix Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424 Mixed Designs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Network Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Organizing within Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426
Recent Trends in Assignments of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . .427 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .432 Appendix: Battle of the Functional Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436
Chapter 14: Attracting and Retaining Qualified Employees . . . . . . 438 Contracting Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .440 The Level of Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441
The Basic Competitive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441 Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .442 Compensating Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .444 Costly Information about Market Wage Rates . . . . . . . . . . . . . . . . . . . . . . . .446
Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .447 Reasons for Long-Term Employment Relationships . . . . . . . . . . . . . . . . . . .447 Costs of Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448
Pay in Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Careers and Lifetime Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .454
The Salary–Fringe Benefit Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employee Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employer Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457 The Salary–Fringe Benefit Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463
Chapter 15: Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . 469 The Basic Incentive Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .470
Incentives from Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473 Optimal Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474
Contents xxiii
Effective Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Principal-Agent Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Informativeness Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .482 Group Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483 Multitasking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .485 Forms of Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .486 Incentive Compensation and Information Revelation . . . . . . . . . . . . . . . . . . .487 Selection Effects of Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488
Does Incentive Pay Work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493 Appendix: Multitasking Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .498
Chapter 16: Individual Performance Evaluation . . . . . . . . . . . . . . . 502 Setting Performance Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .505
Time and Motion Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506 Past Performance and the Ratchet Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . .506
Measurement Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .507 Opportunism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .509
Gaming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510 Horizon Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511
Relative Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511 Within-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .512 Across-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513
Subjective Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513 Multitasking and Unbalanced Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .514 Subjective Evaluation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .515 Problems with Subjective Performance Evaluations . . . . . . . . . . . . . . . . . . .517
Combining Objective and Subjective Performance Measures . . . . . . . . . . . . . . . . .520 Team Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521
Team Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522 Evaluating Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524
Government Regulation of Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .525 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527 Appendix: Optimal Weights in a Relative Performance Contract . . . . . . . . . . . . . .533
Chapter 17: Divisional Performance Evaluation . . . . . . . . . . . . . . . 537 Measuring Divisional Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539
Cost Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539 Expense Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542 Revenue Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .543 Profit Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544 Investment Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544
Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .549 Economics of Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .550 Common Transfer-Pricing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .556 Reorganization: The Solution If All Else Fails . . . . . . . . . . . . . . . . . . . . . . . .560
Internal Accounting System and Performance Evaluation . . . . . . . . . . . . . . . . . . . .560 Uses of the Accounting System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .560 Trade-offs between Decision Management and Decision Control . . . . . . . . .561
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564 Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
Part 4: Applications of Organizational Architecture
Chapter 18: Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . 578 Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580
Corporate Form of Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580 Stock Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Stock Ownership Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Governance Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582
Separation of Ownership and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Incentive Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Survival of Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .583 Benefits of Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . .583
Top-Level Architecture in U.S. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .584 Sources of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585 Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .591 Top Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594 External Monitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598
International Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .601 Market Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604 Sarbanes-Oxley Act of 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .606 Corporate Governance: An Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . .608 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .610 Web Appendix: Choosing among the Legal Forms of Organization . . . . . . . . . . . A-1
Chapter 19: Vertical Integration and Outsourcing . . . . . . . . . . . . . 615 Vertical Chain of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .617 Benefits of Buying in Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .620 Reasons for Nonmarket Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621
Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .624 Taxes and Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .626 Other Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .627
Vertical Integration versus Long-Term Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .627 Incomplete Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Ownership and Investment Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Specific Assets and Vertical Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . .629 Asset Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632 Other Reasons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633 Continuum of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .634
Contract Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635 Contracting with Distributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636
Free-Rider Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636 Double Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638 Regulatory Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .641
xxiv Contents
Trends in Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .642 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .645 Appendix: Ownership Rights and Investment Incentives . . . . . . . . . . . . . . . . . . . .650
Web Chapter 20: Leadership: Motivating Change within Organizations . . . . . . 654
Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Vision Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-4
Decision Making within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5 Incentive Problems and Organizational Politics . . . . . . . . . . . . . . . . . . . . . .20-5 Understanding Attitudes toward Change . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5
Changing Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-7 Proposal Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9
Maintaining Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9 Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10 Distributional Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10
Marketing a Proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Careful Analysis and Groundwork . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Relying on Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Emphasizing a Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-13
Organizational Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Sources of Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Tying the Proposal to Another Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . .20-17 Coalitions and Logrolling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-18 Is Organizational Power Bad? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-19
The Use of Symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-20 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-21 Appendix: Strategic Value of Commitment and Crisis . . . . . . . . . . . . . . . . . . . . .20-23
Chapter 21: Understanding the Business Environment: The Economics of Regulation . . . . . . . . . . . . . . . . . . .655
Importance of Regulation to Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .656 Economic Motives for Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . .658
Defining and Enforcing Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . .658 Redressing Market Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .660 Redistributing Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666
Economic Theory of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .668 Demand for Regulation: Special Interests . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Supply of Regulation: Politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Market for Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .671 Deadweight Losses, Transaction Costs, and Wealth Transfers . . . . . . . . . . . .674
Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Restricting Entry and Limiting Substitutes . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Forming Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .678 On Business Participation in the Political Process . . . . . . . . . . . . . . . . . . . . .679
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .681
Chapter 22: Ethics and Organizational Architecture . . . . . . . . . . . 684 Ethics and Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .687
Contents xxv
Corporate Mission: Ethics and Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Value Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .690 Corporate Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .692 Economists’ View of Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . .693 Corporate Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .695 Mechanisms for Encouraging Ethical Behavior . . . . . . . . . . . . . . . . . . . . . . .698
Contracting Costs: Ethics and Policy Implementation . . . . . . . . . . . . . . . . . . . . . .702 Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .704
Altering Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .705 Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .706 Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .709
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .710
Web Chapter 23: Organizational Architecture and the Process of Management Innovation . . . . . . . . . . . . . . . . .714
Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-3 The Demand for Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-5
The Rise of TQM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-6 Other Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-7
Why Management Innovations Often Fail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Underestimating Costs of Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-11 Failure to Consider Other Legs of the Stool . . . . . . . . . . . . . . . . . . . . . . . .23-12
Managing Changes in Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .23-16 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-19
Index 715
Web Glossary G-1
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chapter
1 C H A P T E R O U T L I N E
Managerial Economics and Organizational Architecture
Organizational Architecture
Economic Analysis
Economic Darwinism
Survival of the Fittest
Economic Darwinism and Benchmarking
Purpose of the Book
Our Approach to Organizations
E nron Corporation was created in 1985 by the merger of two gas pipeline companies. Convinced that impending deregulation of the energy business would create opportunities for firms with the vi- sion to recognize and the willingness to exploit them, Enron moved
aggressively to build and implement an innovative business model. It was a pioneer in the trading of derivative securities tied to assets like natural gas, electricity, and coal. In its transformation from a traditional, capital- intensive gas pipeline company, it established a dramatically smaller re- liance on hard assets, a flatter management structure, and an entrepreneur- ial, risk-taking environment—one that was quite open to creative and unconventional products and practices. It garnered tremendous recognition for these accomplishments; for six years in a row, it was named “Most In- novative” among Fortune’s Most Admired Companies list.
By 2000, Enron operated in several different business segments: transportation and distribution, supplying gas and electric transmission ser- vices; wholesale services, providing energy services and other products to energy suppliers and other firms; retail services, offering business cus- tomers energy products and services; broadband services, providing various service providers with access to a fiber-optic cable network; and other busi- nesses, including water resources and wind energy. In 1990, 80 percent of Enron’s revenues came from its regulated gas pipeline business, but by 2000, over 90 percent of revenues came from its wholesale energy opera- tions and services segment. Enron’s management argued that vertically integrated giants—like ExxonMobil, whose balance sheet was awash with oil reserves, gas stations, refineries, and other hard assets—were dinosaurs. “In the old days, people worked for the assets,” said CEO Jeffrey Skilling. “We’ve turned it around—what we’ve said is the assets work for the people.”
To finance this rapidly expanding array of businesses Enron relied on its bright young CFO, Andrew Fastow. In addition to tapping traditional sources of debt and equity capital, Fastow made extensive use of sophisti- cated partnerships whose financing details were kept off Enron’s balance
Introduction
L E A R N I N G O B J E C T I V E S
1. Define organizational architecture and discuss how economics can be used to
help managers solve organizational problems and structure more effective orga-
nizational architectures.
2. Define Economic Darwinism and discuss its implications related to the bench-
marking of business practices.
P A R T O N E B a s i c C o n c e p t s
2 Part 1 Basic Concepts
sheet.1 For example, to finance its water business, Enron formed Azurix Corporation and raised $695 million by selling one-third of the company to public investors. Enron also formed a partnership called the Atlantic Water Trust in which it held a 50 percent stake. Enron’s partner was Marlin Water Trust, which was marketed to in- stitutional investors. To help attract lenders, Enron guaranteed the debt with its own stock: If Enron’s credit rating fell below investment grade and the stock fell below a stipulated price, Enron itself would be responsible for the partnership’s $915 million debt.
So long as Enron prospered, these guarantees appeared to cost the company little. But several of Enron’s business segments began to experience significant problems. In late summer of 2000, a power shortage in California resulted in blackouts. Enron (along with other energy companies) was blamed by state politicians: California launched an investigation into price gouging by Enron and other power marketers. Enron’s investment in water concessions in Brazil and England ran into political ob- stacles. For instance, British regulators cut the rates that it was allowed to charge its customers. Enron had a 65 percent stake in a $3 billion power project in India. But the power plant became embroiled in a dispute with its largest customer, who refused to pay for electricity. Following the September 11, 2001, terrorist attacks, the pre- cipitous fall in oil prices generated losses for Enron’s trading operations, and tech- nology changes produced a glut of broadband services.
After reaching a peak of nearly $70 billion in August 2000, Enron’s market value collapsed. Its bankruptcy filing in December 2001 is one of the most spectacular business failures ever seen.2 November 2004 saw it emerge from one of the most complex bankruptcies in U.S. history. After 2006 Enron existed as an assetless shell corporation.
What went wrong? According to BusinessWeek,
Enron didn’t fail just because of improper accounting or alleged corruption at the top. . . . The unrelenting emphasis on earnings growth and individual initiative, coupled with a shocking absence of the usual corporate checks and balances, tipped the culture from one that rewarded aggressive strategy to one that increasingly relied on unethical corner cutting. In the end, too much leeway was given to young, inexperienced managers without the necessary controls to minimize failures. This was a company that simply placed a lot of bad bets on businesses that weren’t so promising to begin with.
Thus, BusinessWeek suggests, Enron’s problems were rooted in a fundamentally flawed organizational design. At fault were three key aspects of the company’s cor- porate structure. First, in the course of flattening its management structure, Enron delegated an extraordinary level of decision-making authority to lower-level em- ployees without retaining an appropriate degree of oversight. Second, performance was evaluated largely on near-term earnings growth and success in closing deals. Third, the company offered enormous compensation to its top performers, which en- couraged excessive risk taking. Enron’s internal risk management group was charged with reviewing deals, but the performance appraisals of the 180 employees within the group were based in part on the recommendations of the very people who
1It should be noted that Fastow was recognized by CFO Magazine in October 1999 with their CFO Excellence Award for Capital Structure Management.
2While the largest U.S. corporate bankruptcy at the time, Enron is now far from the largest. Lehman Brothers
($691 billion in 2008), Washington Mutual ($327 billion in 2008), WorldCom ($103.9 billion in 2002),
General Motors ($91 billion in 2009 and CIT Group ($80.4 billion in 2009) were all greater in size.
Chapter 1 Introduction 3
generated the deals. Enron’s problems appear to stem, at least in part, from its organizational design.
Managerial Economics and Organizational Architecture Standard managerial economics books address a number of questions that are im- portant for organizational success:
• Which markets will the firm enter?
• How differentiated will the firm’s products be?
• What mix of inputs should the firm use in its production?
• How should the firm price its products?
• Who are the firm’s competitors, and how are they likely to respond to the firm’s product offerings?
Addressing these questions is certainly important—and in this book, we do—yet this tale of Enron’s implosion suggests that this list is woefully incomplete. It is also im- portant to address questions about the internal organization of the firm. A poorly de- signed organization can result in lost profits and even in the failure of the institution.
With the benefit of hindsight, it seems easy to identify elements of Enron’s orga- nization that, if changed, might have reduced the likelihood of its collapse. But the critical managerial question is whether before the fact one reasonably could be ex- pected to identify the potential problems and to structure more productive organiza- tions. We believe the answer to this fundamental managerial question is a resound- ing yes. To examine these issues, a rich framework that can be applied consistently is required.
We are not, of course, the first to recognize the importance of corporate organiza- tion or to offer analysis of how to improve it. The business section of any good book- store displays a virtually endless array of prescriptions: benchmarking, empower- ment, total quality management, reengineering, outsourcing, teaming, corporate culture, venturing, matrix organizations, just-in-time production, and downsizing. The authors of all these books would strongly agree that the firm’s organization and the associated policies, adopted by management, can have profound effects on per- formance and firm value; and all buttress their recommendations with selected sto- ries of firms that followed their advice and realized fabulous successes.
The problem with such approaches, however, is that each tends to focus on a par- ticular facet of the organization—whether it be quality control, or worker empower- ment, or the compensation system—to the virtual exclusion of all others. As a con- sequence, the suggestions offered by the business press are regularly myopic. These publications tend to offer little guidance as to which tools are most appropriate in which circumstances. The implicit assumption of most is that their technique can be successfully adopted by all companies. This presumption, however, is invariably wrong. Ultimately, this literature fails to provide managers with a productive frame- work for identifying and resolving organizational problems.
Organizational Architecture
In contrast to the approach of most business best sellers, we seek to provide a sys- tematic framework for analyzing such issues—one that can be applied consistently in addressing organizational problems and structuring more effective organizations.
4 Part 1 Basic Concepts
In this book, we offer a framework that identifies three critical aspects of corporate organization:
• The assignment of decision rights within the company
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals and business units
Not coincidentally, these are the same three aspects of the organization we identified in the Enron case.
We introduce the term organizational architecture to refer specifically to these three key aspects of the firm. We hesitate to simply use “organization” to refer to these three corporate features because common usage of that term refers only to the organization’s hierarchical structure—that is, decision-right assignments and report- ing relationships—while it generally ignores the performance-evaluation and reward systems. We thus use organizational architecture to help focus specific attention on all three of these critical aspects of the organization.
Stated as briefly as possible, our argument is that successful firms assign decision rights in ways that effectively link decision-making authority with the relevant infor- mation for making good decisions. When assigning decision rights, however, senior leadership—including both management and the company's Board of Directors— must also ensure that the company’s reward and performance-evaluation systems pro- vide decision makers with appropriate incentives to make value-increasing decisions.
Depending on its specific circumstances, the firm will assign decision-making authority differently (some will decentralize particular decisions but centralize oth- ers) and will tailor its reward and performance-evaluation systems. Even though no two firms might adopt precisely the same architecture, successful firms ensure that these three critical aspects of organizational architecture are coordinated.
Our approach is integrative in the sense that it draws on a number of disciplines: accounting, finance, information systems, marketing, management, operations, politi- cal science, and strategy. But what also distinguishes our approach most clearly from that of the best sellers is our central reliance on the basic principles of economics.
Economic Analysis
Economics long has been applied to questions of pricing policy—for example, “how would raising the price of the firm’s products affect sales and firm value?” We ad- dress standard managerial-economics questions involving pricing, advertising, scale, and the choice of inputs to employ in production. In addition, we apply these same tools to examine questions of organizational architecture. For example, “how would changing a division from a cost center to a profit center change incentives, alter em- ployee decisions, and impact firm value?”
In essence, economics provides a theory to explain the way individuals make choices. For example, in designing organizations, it is important to keep in mind that individuals respond to incentives. Managers and employees can be incredibly re- sourceful in devising methods to exploit the opportunities they face. This also means, however, that when their incentives are structured inappropriately, they can act in ways that reduce the firm’s value. In choosing corporate policies, it is critical that managers anticipate potential responses by customers, suppliers, or employees that might produce undesirable outcomes. Neglecting to do so invites individuals to “game” the system and can result in utter failure of well-intentioned policies.
Chapter 1 Introduction 5
We use economics to examine how managers can design organizations that moti- vate individuals to make choices that will increase a firm’s value. For example, the evidence suggests that the problem highlighted in the accompanying box on chief executive officers slashing R&D budgets prior to their retirement is not widespread.3
The research suggests that these perverse incentives can be controlled by basing the CEO’s incentive compensation on stock prices and by managing CEO succession, so that decision rights are gradually transferred to the successor over the years prior to the final departure. Moreover, CEOs’ postretirement opportunities for election to board seats appear linked to performance over the final years of their tenure.4
Standard economic analysis generally characterizes the firm simply as a “black box” that transforms inputs (labor, capital, and raw materials) into outputs. Little consideration traditionally has been given to the internal architecture of the firm.5 In recent years, economists have focused more on questions of organizational architec- ture.6 But little effort has been devoted to synthesizing the material in an accessible form that emphasizes the managerial implications of the analysis. We apply the basic tools of economics to examine the likely effect on a firm’s value of decisions such as centralization versus decentralization, the bundling of tasks into specific jobs and jobs into business units within the firm, the use of objective versus subjective per- formance measures, compensating employees through fixed versus variable (or “in- centive”) compensation, and retaining activities within the firm versus outsourcing. In sum, we examine how managers can structure organizational architecture to mo- tivate individuals to make choices that increase the firm’s value.
R&D and Executive Turnover Suppose a firm links the CEO’s bonus to earnings and the CEO plans to retire in two years. The CEO might reduce the
firm’s research and development budget to boost earnings this year and next. Five years down the road, earnings will
suffer with no new products coming on stream. By then, however, this CEO will be long gone. In fact, research
suggests that this can be a problem for some R&D-intensive firms.
Source: P. Dechow and R. Sloan (1991), “Executive Incentives and the Horizon Problem,” Journal of Accounting and Economics 14, 51–89.
A C A D E M I C A P P L I C AT I O N S
3K. Murphy and J. Zimmerman (1993), “Financial Performance Surrounding CEO Turnover,” Journal of Accounting and Economics 16, 273–315.
4J. Brickley, J. Linck, and J. Coles (1999), “What Happens to CEOs after They Retire? New Evidence on
Career Concerns, Horizon Problems, and CEO Incentives,” Journal of Financial Economics 52, 341–378. 5Of course, there are several notable exceptions: F. Knight (1921), Risk, Uncertainty, and Profit (London School of Economics: London); R. Coase (1937), “The Nature of the Firm,” Economica 4, 386–405; and F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.
6For example, R. Coase (1960), “The Problem of Social Cost,” Journal of Law and Economics 3, 1–44; S. Cheung (1969), “Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements,” Journal of Law and Economics 12, 23–42; A. Alchian and H. Demsetz (1972), “Production, Information Costs, and Economic Organization,” American Economic Review 62, 777–795; K. Arrow (1974), The Limits of Organization (W. W. Norton: New York); M. Jensen and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305–360; Y. Barzel (1982), “Measurement Costs and the Organization of Markets,” Journal of Law and Economics 25, 27–48; O. Williamson (1985), The Economic Institutions of Capitalism: Firms, Markets, Rational Contracting (Free Press: New York); and B. Holmstrom and J. Tirole (1989), “The Theory of the Firm,” in R. Schmalensee and R. Willig (Eds.), Handbook of Industrial Economics (North-Holland: New York).
6 Part 1 Basic Concepts
In this analysis, ideas of equilibrium—the interplay of supply and demand in product, labor, and capital markets—represent important constraints on manager- ial decisions. Understanding how prices and quantities change in response to changes in costs, product characteristics, or the terms of sale is a critical manage- rial skill. For example, the more than five-fold increase in crude oil prices from below $12 per barrel in 1999 to over $135 in 2008 prompted oil companies to
M A N A G E R I A L A P P L I C AT I O N S
Economic Incentives and the Subprime Mortgage Crisis “Subprime mortgages” are made to borrowers who do not qualify for standard market interest rates because of
problems with their credit histories or inability to prove that they have enough income to support the monthly
payments. In March 2007, the value of U.S. subprime mortgages was estimated at $1.3 trillion with over 7.5 million
mortgages outstanding. During the second half of 2007, investors in subprime mortgages such as banks, mortgage
lenders, real estate investment trusts, and hedge funds reported losses of close to $100 billion as a result of subprime
mortgage defaults and devaluations. The stock market fell and became quite volatile as more details about the
mortgage crisis were revealed over time.
One important factor that contributed to this crisis was the incentives of the mortgage brokers that originated the
loans. Mortgage brokers, who originated nearly 70 percent of residential mortgages in recent years, don’t lend their
own money. They are paid for originating loans, which are sold to other investors who bear the primary risk. In many
cases, the more loans they originate, the higher their compensation.
The financial incentives for originating mortgages motivated financial companies to offer products that made it
easier for borrowers to qualify for the loans. For example, companies began offering “stated income loans” that
required no proof of income. Consistent with the theory in this book, some borrowers overstated their incomes. In a
recent review of 100 of these so-called liar loans, almost 60 percent of the stated amounts were exaggerated by over
50 percent. For example, in Atlanta a borrower received a $1.8 million loan by stating that he and his wife were top
executives at a marketing firm who earned more than $600,000 per year with personal assets totaling $3 million. In
reality, he was a phone company technician who earned $105,000 per year with savings of only $35,000.
The financial incentives and associated lack of controls produced not only risky loans but also billions of dollars of
fraud. Rings of fraudulent borrowers would (1) recruit people with good credit to apply for very large loans using false
income and asset statements, (2) find home appraisers to significantly inflate the values of the underlying properties,
(3) pay the much lower asking prices to the sellers, and (4) pocket the difference, splitting the proceeds among the
members of the ring. The houses then would go into foreclosure as the loans were not repaid.
Banking executives subsequently testified that they did not foresee this problem—“fraud was not really a
consideration in our world.” The premise of this book is that a careful analysis of the underlying organizational
architecture (incentives and decision-right assignments) can help managers anticipate these types of problems and
develop mechanisms to reduce their severity.
Source: M. Corkery (2007), “Fraud Seen as a Driver in Wave of Foreclosures,” The Wall Street Journal (December 21), A1.
M A N A G E R I A L A P P L I C AT I O N S
Creative Responses to a Poorly Designed Incentive System A manager at a software company wanted to find and fix software bugs more quickly. He devised an incentive plan that
paid $20 for each bug the Quality Assurance people found and $20 for each bug the programmers fixed. Since the
programmers who created the bugs were also in charge of fixing them, they responded to the plan by creating bugs in
software programs. This action increased their payoffs under the plan—there were more bugs to detect and fix. The
plan was canceled within a single week after one employee netted $1,700 under the new program.
Source: S. Adams (1995), “Manager’s Journal: The Dilbert Principle,” The Wall Street Journal (May 22), A12.
Chapter 1 Introduction 7
increase production, encouraged petrochemical companies to alter their input mix to economize on a now-more-expensive input, made salespeople reevaluate their decisions about contacting potential customers by phone rather than in person, and encouraged auto producers to focus more on gas economy in the design of new models. Yet these incentives to change depend on the structure of the organization. For instance, a salesperson is less likely to switch to greater reliance on telephone and mail when the firm reimburses all selling expenses than when salespeople are responsible for the costs of contacting potential customers.
Economic Darwinism
Survival of the Fittest7
The collapse of Enron, Charles Darwin might have noted, is an example of how com- petition tends to weed out the less fit. As described in The Origin of Species, natural history illustrates the principle of “survival of the fittest.” In industry, we see economic Darwinism in operation as competition weeds out ill-designed organiza- tions that fail to adapt. Competition in the marketplace provides strong pressures for efficient decisions—including organizational decisions. Competition among firms dictates that those firms with low costs are more likely to survive. If firms adopt in- efficient, high-cost policies—including their organizational architecture—competi- tion will place strong pressures on these firms to either adapt or close.
Fama and Jensen suggest that “the form of organization that survives in an activ- ity is the one that delivers the product demanded by customers at the lowest price while covering costs.” This survival criterion helps highlight that while a well- crafted organizational architecture can contribute to a firm’s success, it is not suffi- cient for success. The firm must have a business strategy that includes products for which the prices customers are willing to pay exceed costs. The potential for value creation by a company that manufactures only buggy whips is quite limited no mat- ter how well structured the firm’s organizational architecture.
Nonetheless, given a firm’s business strategy (including its product mix), its choice of organizational architecture can have an important impact on profitability and value. An appropriate architecture can lower costs by promoting efficient pro- duction; it also can boost the prices customers are willing to pay by helping to ensure high-quality production, reliable delivery, and responsive service.
Economic Darwinism and Benchmarking
In the biological systems that Darwin analyzed, the major forces at work were ran- dom mutations in organisms and shocks from the external environment (for instance, from changes in weather). But in the economic systems on which we focus, pur- poseful voluntary changes occur. For instance, in order to compete more effectively with Coke, Pepsi copied many of Coke’s practices. Pepsi spun off its fast-food chains
7This section draws on A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221; G. Stigler (1951), “The Economics of Scale,” Journal of Law and Economics 1, 54–71; and E. Fama and M. Jensen (1983), “Separation of Ownership and Control,” Journal of Law and Economics 26, 301–325.
8 Part 1 Basic Concepts
(Taco Bell, KFC, and Pizza Hut) to focus on its core business—just as Coca Cola had done. Also, Pepsi changed its network of bottlers. One analyst remarked, “Pepsi is starting to look a lot more like Coke.”8 In fact, this practice has been formalized in the process of benchmarking.
Benchmarking generally means looking at those companies that are doing some- thing best and learning how they do it in order to emulate them. But this process also occurs in less formal ways. As Armen Alchian argued, “Whenever successful enter- prises are observed, the elements common to those observed successes will be asso- ciated with success and copied by others in their pursuit of profits or success.”9 For example, if the cover article in the next Fortune reports an innovative inventory con- trol system at Toyota, managers across the country—indeed, around the globe—will read it and ask, Would that work in my company, too? Undoubtedly, the managers with the strongest interest in trying it will be those within firms currently suffering inventory problems.10 Some will achieve success, but others may experience disas- trous results caused by unintended though largely predictable organizational “side effects” (like Fastow’s unchecked incentive for risk taking).
8N. Harris (1997), “If You Can’t Beat ’Em, Copy ’Em,” BusinessWeek (November), 50. 9A. Alchian. “Uncertainty, Evolution, and Economic Theory,” The Journal of Political Economy, Vol. 58, No. 3 (Jun., 1950), p. 218.
10This raises the question of why any firm with an innovative idea would voluntarily disclose it. Perhaps the
free publicity outweighs the lost competitive advantage.
M A N A G E R I A L A P P L I C AT I O N S
Economic Darwinism: The Growth in Lead Directors The collapse of Enron in December 2001 and subsequent scandals at Adelphia, Tyco, WorldCom, and other companies
in 2002 shook public confidence in corporate governance. In July 2002, the United States enacted the Sarbanes–Oxley
Act, which mandated substantial changes in corporate accounting and governance practices. Additional scandals and
failures during the 2007–2008 financial crisis raised additional concerns about corporate governance and motivated
additional legislation and regulation.
These events altered the basic business environment for publicly traded corporations. Over the past decade,
investors, regulators, stock exchanges, the media and the general public have placed increased pressure on corporate
boards of directors to become more independent and diligent in their monitoring of CEOs. One important trend in
corporate governance has been the large increase in presiding and lead directors. Presiding directors are independent
directors (a director with no other direct ties to the company or corporate management) who chair executive sessions of
outside directors. Lead directors are more powerful, taking on additional responsibilities (such as serving as the
principal liaison between the independent directors and the CEI and taking the lead role in overseeing formal
evaluations of board members and the CEO). In 2003, only 36 percent of S&P 500 firms had presiding or lead
directors, compared to 90 percent in 2013. Over 60 percent of the S&P 500 firms with presiding or lead directors in
2013 employed the more powerful position of lead director.
If you were to benchmark the current governance practices of large publicly traded corporations, you would find the
appointment of a lead director is a dominant surviving practice in the current business environment. “One size,”
however, is unlikely to fit all firms. Managers should not simply adopt the prevailing organizational practices of other
firms. More careful analysis is required.
Source: Spencer Stuart (2013), “Spencer Stuart Board Index 2013,” www.spencerstuart.com.
Chapter 1 Introduction 9
Although competition tends to produce efficiently organized firms over the longer run, uncritical experimentation with the organizational innovation du jour can ex- pose the firm to an uncomfortably high risk of failure. Organizational change is ex- pensive. Moreover, successful organizations are not just a collection of “good ideas.” The elements of a successful organization must be carefully coordinated: The differ- ent elements of the firm’s architecture must be structured to work together to achieve the firm’s goals. For this reason, it is important to be able to analyze the likely con- sequences of a contemplated organizational change and forecast its impact on the en- tire firm.
This concept of economic Darwinism thus has important managerial implica- tions. First, existing architectures are not random; there are sound economic ex- planations for the dominant organization of firms in most industries. Second, sur- viving architectures at any point in time are optimal in a relative rather than an absolute sense; that is, they are the best among the competition—not necessarily the best possible. Third, if the environment in which the firm operates changes—if technology, competition, or regulation change—then the appropriate organiza- tional architecture normally changes as well. These three observations together suggest that although improvements in architecture are certainly always possible, a manager should resist condemning prevailing structures without careful analysis. Before undertaking major changes, executives should have a good understanding of how the firm arrived at its existing architecture and, more generally, develop a broader perspective of why specific types of organizations work well in particular settings. Finally, an executive should be particularly skeptical of claimed benefits of proposed organizational changes if the environment has been relatively stable.
Purpose of the Book The primary thrust of this book is to provide a solid conceptual framework for ana- lyzing organizational problems and structuring an effective organizational architec- ture. The book also provides basic material on managerial economics and discusses how it can be used for making operational decisions—for example, input, output, and pricing decisions. This material additionally supplies a set of tools and an un- derstanding of markets, that is, important for making good organizational decisions.
M A N A G E R I A L A P P L I C AT I O N S
Organizing Xerox Service Center Xerox has developed an expert system to assist employees who answer the company service center’s 800 number to
help callers who have problems with their photocopy machines. The system is designed to lead the employee through a
set of questions to diagnose and fix the problem. If the machine operator cannot fix the problem with the assistance of
the input from the service center employee, a service representative is dispatched to make a service call. This expert
system is designed to evolve more effective prompts as experience accumulates. This will be accomplished by having
service representatives call the service center after a service call. The nature of the problem and the actions taken are to
be entered into the system. Xerox bases pay for the individuals who answer the 800 number on the number of service
calls they handle; it bases compensation for service representatives on the number of service calls they make. Discuss
the incentives these compensation practices create.
10 Part 1 Basic Concepts
Our Approach to Organizations
We begin with two basic notions: People act in their own self-interest, and individu- als do not all share the same information. As we have indicated, this framework sug- gests that the three critical elements of organizational architecture are the assignment of decision rights, the reward system, and the performance-evaluation system. Suc- cessful organizations assign decision rights in a manner that effectively links deci- sion-making authority with the relevant information to make good decisions. Corre- spondingly, successful organizations develop reward and performance-evaluation systems that provide self-interested decision makers with appropriate incentives to make decisions that increase the values of their organizations.
It is also important to note that modern organizations are extremely complex and that developing an understanding of how people within them behave is difficult. As in any book that addresses this set of topics, we face difficult trade-offs between adding more institutional richness to infuse more texture of the actual environment versus omitting details to keep the analysis more focused and manageable. At certain points (especially where little prior formal analysis of the problem exists), we take quite complex problems and discuss them in terms of simplified examples. Nonethe- less, our experience suggests that in these cases, we derive important managerial in- sights to these topics through our admittedly simple examples.
Finally, we believe that a powerful feature of this economic framework is that it can be extended readily to incorporate a broad array of other managerial policies such as finance, accounting, information systems, human relations, operations, and marketing. In this sense, this book can play an important integrating role across the entire business curriculum. Such integration is becoming increasingly important with the expanded use of cross-functional teams within the business community.
M A N A G E R I A L A P P L I C AT I O N S
Transfers of Organizational Architecture across the Global Economy In 1996, Tianjin Optical & Electrical Communication Group was typical of a Chinese state-owned company. Although
the electronics manufacturer boasted skilled technicians, mismanagement left the company at the brink of bankruptcy.
Motorola, Inc., changed that. It offered to take Tianjin Optical as a supplier, but only if Tianjin adopted the U.S.
telecommunications company’s quality-control and management practices. By 1999, Tianjin Optical was selling a third
of its production to Motorola and reported a small profit. “Now, we think we can survive,” says Zhang Bingjun, Tianjin
Optical’s chairman.
Each Tianjin employee receives an average of two weeks a year in classroom instruction stressing modern
management practices. That effort has paid off: The Tianjin assembly lines produce a slim cellular phone every 2
seconds with virtually the same defect rate as in Motorola’s U.S. plants. Motorola also provides training for more than
100 outside suppliers to boost the quality of their output. Motorola budgets about $2 million annually to “show
[potential suppliers] Western management practices and create a mindset where they understand what we’re doing and
why,” says a training director, Ying Shea.
This assistance in establishing a more effective organizational architecture and internal operating policies provided
by a U.S. multinational corporation to its Chinese partners is but one example of the vital role that foreign businesses
play within the Chinese business sector. Since China opened itself to foreign investment three decades ago, foreign
companies have become an important conduit for economic reform. They have introduced not just modern production
technology but also more efficient organizational architecture to the Chinese business community. Some estimates
suggest that including these collateral benefits, foreign firms and their joint ventures account for as much as a fifth of
China’s trillion-dollar economy.
Source: E. Guyot (1999), “Foreign Companies Bring China More Than Jobs,” The Wall Street Journal (September 15), A26.
1 2
Chapter 1 Introduction 11
ANALYZING MANAGERIAL DECISIONS: Société Générale
Société Générale was founded in the 1860s and in
2013 was France’s third largest bank. Beginning in
the mid-1980s, it pioneered some of the most com-
plex instruments in international finance and became
a global powerhouse in trading derivatives like futures
and options. Through its trading activities, the bank
earned billions of dollars and gained the respect of
bankers throughout the world. In January 2008, Risk, a monthly magazine about risk management, named
Société Générale its “Equity Derivatives House of the
Year.”
In late January 2008, Société Générale an-
nounced that it had discovered fraudulent securities
trading by one of its low-level traders, Jérôme
Kerviel. The bank reported that it expected the
fraud to cost it a staggering $7.14 billion, making it
one of the largest financial frauds in history. The
announcement shocked the financial markets and
made front-page headlines around the world. Ob-
servers questioned whether the bank could ever re-
gain its former reputation and whether it could con-
tinue to exist without merging with another bank.
Société’s CEO Daniel Bouton asserted that the
fraud was the result of one employee’s illegal activ-
ities, did not involve other employees at the bank,
and represented the aberrant and unexplainable ac-
tions of one “rogue trader.” He characterized
Kerviel’s actions as “irrational” since the trades
were made on behalf of the bank “netting the trader
no personal gains.” Bouton emphasized that
Kerviel was a low-level employee who had an an-
nual salary and bonus for 2007 of less than
$145,700.
In principle Kerviel engaged in a quite simple
operation: arbitrage-trading on small differences
between various stock market indexes such as the
CAC in France and the DAX in Germany. Kerviel
should have been able to lock in a virtually riskless
profit by selling a security on the exchange with the
higher price, while simultaneously buying an equiv-
alent instrument on the exchange with the lower
price. And although price differences are typically
small, such arbitrage can produce a substantial profit
if done in sufficient volume. In this arbitrage busi-
ness, although Société Générale might accumulate
large positions on both exchanges, those securities
that it bought and those it sold should balance. The
bank was supposed to face little net exposure to
price changes.
What the bank discovered was that Kerviel had
bought securities on both markets. In effect, he had
made enormous bets that European stock prices
would increase. But they had fallen, and as a result
the bank incurred a substantial loss.
The subsequent investigation revealed that
Kerviel had been placing huge unhedged bets on
European stocks for over a year. Prior to becoming
a trader he had worked in the bank’s trading ac-
counting office. His knowledge of the bank’s risk-
management system allowed him to conceal the
trades and bypass the firm’s control system. He
knew the timing of the nightly reconciliation of the
day’s trades and would delete and then re enter his
unauthorized transactions without being caught.
Bank managers, however, had apparently dismissed
several warning signs about Kerviel’s transactions.
For example, the surveillance office at Eurex, one
of Europe’s biggest exchanges, alerted a compli-
ance officer at the bank that for seven months a
trader named Kerviel had engaged in “several
transactions” that raised red flags. Kerviel’s super-
visors accepted his explanations for these trades
apparently without much investigation.
Various bank officials, investigators, and traders
who worked with Kerviel have concluded that So-
ciété Générale “allowed a culture of risk to flour-
ish, creating major flaws in its operations” that en-
abled Kerviel’s actions to proceed. Several current
and former employees interviewed by the New York Times, indicated that Société Générale traders were rewarded for making risky investments with
the bank’s money and that it was not uncommon
for traders briefly to exceed limits imposed on their
trading, despite controls meant to prohibit this ac-
tivity. Risk taking apparently was “embraced, as
long as it made money for the bank.” Top execu-
tives and other managers at the bank had received
large bonuses because of the bank’s successful
trading operations.
Kerviel told investigators that all he wanted was to
be respected and to earn a large bonus. He had come
from a modest background and did not have the
12 Part 1 Basic Concepts
A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221.
M. Jensen (1983), “Organization Theory and Methodology,” The Accounting Review 58, 319–339.
M. Jensen and W. Meckling (1992), “Specific and General Knowledge, and Organizational Struc-
ture,” Journal of Applied Corporate Finance 8:2, 4–18.
1–1. Briefly describe Economic Darwinism.
1–2. The Wall Street Journal 11 reports that
Franchisees, who pay fees and royalties in exchange for using franchisers’ business formats, have become much more militant in recent years about what they see as mistreatment by franchisers. In general, Ms. Kezios is seeking federal and state laws to give franchisees more power in franchise arrangements. Among her goals: creating legally pro- tected exclusive territories for franchisees.
How would you expect existing franchisees to react to this proposed regulation? How
would you expect a potential new franchisee to react to this proposed regulation?
Solutions to Self-Evaluation Problems 1–1. Economic Darwinism is the economic counterpart of natural selection in biology. Competi-
tion in the marketplace weeds out those organizations that are less efficient and fail to adapt
to the environment. The result is survival of the fittest.
1–2. Reducing the likelihood of encroachment by the franchiser benefits the existing franchisees to the extent that it shifts future profits from the franchiser to the franchisee. Thus, existing
franchisees are likely to favor the proposed regulation. Potential new franchisees are less
likely to favor the proposal. Presumably, they will have to pay a higher price for a new fran-
chise if the franchiser has to grant the franchisee an exclusive territory. The potential fran-
chisee might prefer to have a nonexclusive territory at a lower price. In any case, the fran-
chiser is unlikely to favor the proposal; if it were efficient to convey exclusive territories, the
original contract could have been structured that way.
1–1. What are the three aspects of organizational architecture?
1–2. In the process of benchmarking, a colleague of yours notes that Lincoln Electric, a producer of electric arc welders, has much higher productivity than does your company. Unlike your
Review Questions
Self-Evaluation Problems
Suggested Readings
educational pedigree of many of his coworkers who
had advanced degrees in math or engineering from
the prestigious Grandes Ecoles—the MITs of France.
He was noted for working very long hours and had
worked his way up in the bank from being a clerk to
a trader. One of his primary goals was to have his
supervisors recognize his “financial genius.”
1. Do you agree with Société Générale’s CEO
that Kerviel’s actions were “irrational”?
2. Discuss how the bank’s organizational archi-
tecture contributed to the problem.
3. What lessons might you learn from this case if
you were an executive at another bank?
Source: This application is based on a series of articles from the New York Times published in early 2008. In particular see N. D. Schwartz and K. Bennhold, 2008, “A Trader’s Secrets, a Bank’s Missteps,” nytimes.com (February 5).
11J. A. Tannenbaum (1995), “Focus on Franchising: Franchisee Gains,” The Wall Street Journal (June 19), B2.
Chapter 1 Introduction 13
firm, Lincoln has an extensive piece-rate compensation system; much of its employees’
total compensation is simply the number of units produced times the piece rate for that type
unit. Your colleague recommends that your company adopt a piece-rate compensation sys-
tem to boost productivity. What do you advise?
1–3. In the life insurance industry, we see two major ownership structures—common stock in- surers and mutual insurers. In a common stock company, the owners—its stockholders—are
a separate group from its customers—the policyholders. In a mutual, the policyholders are
also the owners of the company. It has been argued that mutual insurance companies are
dinosaurs—they are large, slow, bureaucratic, and inefficient. How would you respond to
such an argument?
chapter
2 C H A P T E R O U T L I N E
Economic Behavior: An Overview
Economic Choice Marginal Analysis Opportunity Costs Creativity of Individuals
Graphical Tools Individual Objectives Indifference Curves Opportunities and Constraints Individual Choice Changes in Choice
Motivating Honesty at Merrill Lynch Managerial Implications Alternative Models of Behavior
Only-Money-Matters Model Happy-Is-Productive Model Good-Citizen Model Product-of-the- Environment Model
Which Model Should Managers Use? Behavioral Economics Decision Making under Uncertainty
Expected Value Variability Risk Aversion Certainty Equivalent and Risk Premium Risk Aversion and Compensation
Summary Appendix A: Consumer Choice Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem
I n May 2002, Merrill Lynch agreed to pay $100 million to settle charges that its analysts had recommended stocks to clients that they privately thought were poor investments. Internal e-mails provided strong sup- port for this claim leveled by the New York State attorney general. For
example, InfoSpace, an Internet services company, was rated highly in ana- lysts’ reports distributed to clients, yet privately the analysts suggested that it was a “powder keg” and a “piece of junk.” Although InfoSpace’s share price dropped from $261 to $14, Merrill analysts never recommended sell- ing the stock. Merrill analysts rated Excite@Home “accumulate or buy,” while privately the investment team called it a “piece of crap.”
This episode at Merrill sent shock waves through other major investment houses—indeed through the entire investment community. Other investment firms publicly stated that they were taking strong steps to make sure that the situation at Merrill would not be repeated within their organizations. Fortune magazine ran a cover story entitled, “In Search of the Last Honest Analyst.”1 The scandal generated significant concerns throughout the world among both the general public and government regulators. For example, the New York attorney general began a sweeping investigation of analysts at Salomon Smith Barney and other investment firms that had recommended WorldCom to investors. In July 2002, WorldCom became the biggest company ever to file for bankruptcy in U.S. history. In December 2002, the nation’s 10 top investment banks agreed to a $1.2 billion settlement with regulators aimed at “protecting investors from brokerages’ conflicts of interest.”
Economists’ View of Behavior
L E A R N I N G O B J E C T I V E S
1. Describe the economic model of behavior. 2. Define and apply marginal analysis in managerial decisions. 3. Define and apply the concept of opportunity costs. 4. Use graphs to explain, predict, and affect behavior in a wide range of
applications.
5. Contrast the implications of the economic model with those from other behavioral models used by some managers.
6. Identify the key concepts that are used to mitigate risk when making decisions under uncertainty.
1June 10, 2002, issue.
Chapter 2 Economists’ View of Behavior 15
Managers at Merrill, Salomon Smith Barney, and other investment companies had to act quickly to address this potential problem. As a first step, management had to understand what motivated the Merrill analysts to mislead their investment clients. Only then could they choose a policy to redress the situation. If management thought this problem was caused by a few dishonest employees, the appropriate response would have been to try to identify and fire those employees. If, instead, management believed the problem was caused by disgruntled employees taking out their frustra- tions on customers, a potential response would have been to adopt a job-enrichment program to increase employee satisfaction and, it would be hoped, analyst honesty. Alternatively, Merrill Lynch might have created incentives through its compensation plan that caused its analysts to issue misleading investment reports. If so, the appro- priate response would be to restructure its compensation plan. Many other assump- tions and responses are possible.
The example of Merrill Lynch illustrates a general point: Managers’ responses to problems are likely to depend on their understanding of people’s motives and their forecast of people’s reactions—their responses thus depend on their underlying model of behavior. Most managerial actions attempt to change the behavior of indi- viduals, such as employees, customers, union officials, or subcontractors. Managers with different understandings (or models) of what motivates behavior are likely to make different decisions and take different actions.
We begin this chapter by briefly summarizing the general framework economists use to examine individual behavior. Selected graphical tools are introduced to aid our analysis. Next, we use this economic framework to analyze the problem at Merrill Lynch. The managerial implications of this analysis are discussed. We contrast this economic view of behavior with alternative views and explore why the economic framework is particularly useful in managerial decision making. Finally, we analyze decision making under uncertainty. In Appendix A, we analyze the problem of con- sumer choice in more detail and in Appendix B, we illustrate how the graphical frame- work we present in this chapter can be used for analyzing inter-temporal choices.
Economic Behavior: An Overview Individuals have unlimited wants. People generally want greater wealth, more atten- tive service, larger houses, more luxurious cars, and additional personal material items. They want more time for leisure activities. Most also want to improve the plight of others—starving children, the homeless, and disaster victims. People are concerned about vitality, religion, integrity, and gaining the respect and affection of others.
In contrast to wants, resources are limited. Households face limited incomes that preclude all the purchases and expenditures that household members might like to make. The available amount of land, trees, and other natural resources is finite. There are only 24 hours in a day. People become ill; death is inevitable.
Economic Choice
Economic analysis is based on the notion that individuals assign priorities to their wants and choose their most preferred options from the available alternatives. If Kathy Measer is confronted with a choice between a laptop or a desktop computer, she can tell you whether she prefers one over the other or whether she is indifferent
16 Part 1 Basic Concepts
between the two. Depending on the relative prices of the two products, she purchases her preferred alternative. If Kathy has a weekly budget of $1,000, she considers the many ways she might spend the money and then chooses the package of goods and services that will maximize her personal happiness. She cannot make all desired pur- chases on her limited budget. However, this choice is optimal for Kathy, given her limited resources.
Economists do not assert that people are selfish in the sense that they care only about their own personal consumption. Within the economic paradigm, people also care about such things as charity, family, religion, and society. For instance, Kathy will donate $100 to her church, as long as the donation provides greater satisfaction than alternative uses of the money.
Economists, however, often assume for modeling purposes that people care only about their own wealth to simplify the analysis. While wealth is not the only thing that people care about, it is very important to most people. Economic models based on this simplifying assumption often perform quite well relative to more complicated models that add unnecessary complexity to the analysis. Some situations, however, can require models that are based on different assumptions.
Economists do not contend that individuals are supercomputers that make infalli- ble decisions. Individuals are not endowed with perfect knowledge and foresight, nor is additional information costless to acquire and process.2 For example, Kathy might order an item from a restaurant menu only to find that she dislikes what she is served. Within this economic paradigm, she simply does the best she can in the face of her imperfect knowledge. But she learns from her experience and does not repeat the same mistakes in judgment time after time.3
Marginal Analysis
Marginal costs and benefits are the incremental costs and benefits that are associated with making a decision.4 It is the marginal costs and benefits that are important in economic decision making. An action should be taken whenever the incremental benefits of that action exceed its incremental costs. Mary O’Dwyer has a contract to help sell products for an office supply company. She is paid $50 for every sales call that she makes to customers. Thus, Mary’s marginal benefit for making each addi- tional sales call is $50. Mary enjoys playing tennis more than selling. If she places a marginal value of more than $50 on the tennis that she would forgo by making an
2Economists sometimes use the idea of bounded rationality. Under this concept, individuals act in a purposeful and intendedly rational manner. However, they have cognitive limitations in storing, processing, and communicating information. It is these limitations which make the question of how to organize economic
activity particularly interesting. H. Simon (1957), Models of Man (John Wiley & Sons: New York). 3At least this learning appears to occur outside the comics. For decades, Charlie Brown from Peanuts continued to try to kick the football held by Lucy van Pelt. Yet Lucy always pulled the ball at the last second.
Few individuals are as incurably optimistic as Charlie Brown—they learn. 4Technical note: Marginal costs and benefits are typically defined as changes in costs and benefits associated with very small changes in a decision variable. For instance, the marginal costs of production are the additional costs from producing a small additional amount of the product (for instance, one more unit). Often
decisions involve discrete choices, such as whether or not to build a new plant. In these cases, it is not
possible to define a small change in the decision variable. Incremental costs and benefits are those costs and benefits which vary with such a decision. For our present discussion, the technical distinction between
marginal and incremental is not important.
Chapter 2 Economists’ View of Behavior 17
extra call, she should not make any more sales calls that day—the marginal costs would have exceeded the marginal benefits. She continues to make additional sales calls as long as the reduction in tennis playing is valued at less than $50.5
Marginal analysis is a cornerstone of modern economic analysis. In economic de- cision making, “bygones are forever bygones.” Costs and benefits that have already been incurred are sunk (assuming they are nonrecoverable) and hence are irrelevant to the current economic decision. Mary paid $5,000 to join a tennis club last month. This fee does not affect her current decision of whether to play tennis or make an extra sales call. That expenditure is ancient history and does not affect Mary’s cur- rent trade-offs.
As another example, consider Ludger Hellweg who owns a company that installs wood floors. He is offered $20,000 to install a new floor. The cost of his labor and other operating expenses (excluding the wood) are $15,000. He has wood for the job in inventory. It originally cost him $2,000. Price increases have raised the market value of the wood to $6,000, and this value is not expected to change in the near fu- ture. Should he accept the contract?
He should compare the incremental costs and benefits from the project. The mar- ginal benefit is $20,000. The marginal cost is $21,000—$15,000 for the labor and operating expenses and $6,000 for the wood. The historic cost for the wood of $2,000 is not relevant to the decision. To replace the wood used on this job costs
M A N A G E R I A L A P P L I C AT I O N S
Marginal Analysis of Customer Profitability Banks often provide multiple products and services to the same customer (checking and savings accounts, mortgages,
lines of credits, business loans, credit cards, international banking services, insurance, and so on). In the 1980s, most
banks did not consolidate this information, and so it was difficult to determine if serving a given customer was
profitable or not. Today many banks use “profitability software” to consolidate information on each customer. Many
banks have found to their surprise that the incremental costs for serving many of their customers are larger than the
incremental revenues. Fleet Bank, for example, found that as many as one-half of their customers were unprofitable.
Armed with this information, banks work hard to maintain high-profit customers, while they either eliminate or alter
services to unprofitable customers. For example, at many banks profitable customers are given special designations,
such as “Gold Customer Status,” and the banks extend special services to them. Preferred customers are frequently
given special toll free lines; branch managers are furnished with their names and are instructed to meet and greet them
when they visit a branch. They are assigned personal bankers, who call and introduce themselves. Customers are
assigned profitability codes, for example, so employees can know whether they are dealing with a 5, 4, 3, 2, or 1 type
customer (five being most profitable). When the loans for unprofitable customers come up for renewal, they are
renewed at a higher rate, to try to nudge them into profitability, or possibly to get the customers to take their business
elsewhere. In contrast, loan applications by customers in the 4 and 5 categories are quickly processed and given special
attention. Banks provide but one example of how firms are making increased use of information technology to do more
sophisticated marginal analysis—devoting their efforts to customers and products where the incremental revenues are
greater than the incremental costs and eliminating and avoiding unprofitable activities.
Source: A. Hughes (2014), “How Banks Use Profitability Analysis,” Database Marketing Institute, www.dbmarketing.com/ articles/Art195.htm.
5To keep this example simple, we abstract from several issues. We ignore any pleasure Mary receives from the
process of selling. Also, selling effort today is likely to have some effect on her future professional progress.
Finally, if Mary values a tennis game at 9 A.M. and one at 7 P.M. equally, she will sell during the business day
and postpone tennis to the evening.
18 Part 1 Basic Concepts
$6,000. Since the marginal costs exceed the marginal benefits, Ludger would be bet- ter off rejecting the contract than accepting it. This example illustrates that in calcu- lating marginal costs, it is important to use the opportunity cost of the incremental resources, not their historic (accounting) cost.
Opportunity Costs
Because resources are constrained, individuals face trade-offs. Using limited re- sources for one purpose precludes their use for something else. For example, if Larry Matteson takes four hours to play golf, he cannot use that same four hours to paint his house. The opportunity cost of using a resource for a given purpose is its value in its best alternative use. The opportunity cost of using four hours to play golf is the value of using the four hours in Larry’s next best alternative use.
Marginal analysis frequently involves a careful consideration of the relevant op- portunity costs. If Larry starts a new pizza parlor and hires a manager at $30,000 per year, the $30,000 is an explicit cost (a direct dollar expenditure). Is he better off man- aging the restaurant himself, since he can avoid the explicit cost of $30,000 by not paying himself a salary? The answer to this question depends (at least in part) on the opportunity cost of his time. If he can earn exactly $30,000 in his best alternative job, the implicit cost of self-management is the same as the explicit cost of hiring an out- side manager: He forgoes $30,000 worth of income if he manages the parlor himself. Both explicit and implicit costs are opportunity costs that should be considered in the analysis. Suppose that Larry’s gross profit from the pizza parlor, before paying the manager a salary, is $35,000 and that he can earn $40,000 in an outside job. Hiring a manager for $30,000 yields a net profit of $5,000 from the pizza parlor. He also earns $40,000 from the outside job, for total earnings of $45,000. If he manages the pizza parlor himself, he earns only $35,000. In this example, it is better for him to work at the outside job and hire a manager to run the restaurant.6
Creativity of Individuals7
Within this economic framework, individuals maximize their personal satisfaction given resource constraints. Indeed, people are quite creative and resourceful in min- imizing the effects of constraints. For instance, when the government adopts new
M A N A G E R I A L A P P L I C AT I O N S
Opportunity Costs and V-8 The Campbell Soup Company used the idea of an opportunity cost to create a successful ad campaign for its V-8
vegetable juice. Upon finishing a soft drink, the fellow in the ad would look into the camera, slap his forehead, and
exclaim: “Wow—I coulda had a V-8.” Since one is unlikely to drink both a soft drink and a V-8, the opportunity cost of
the soft drink is the forgone V-8—a cost that these commercials sought to convince the viewing audience is quite high.
6Again, to keep the example simple, we assume there is no difference in personal satisfaction between Larry’s
outside job and managing the pizza parlor. We also postpone the discussion of consequences for the success
of the pizza parlor from hiring a manager versus self-management until Chapter 10. 7This section draws on W. Meckling (1976), “Values and the Choice of the Model of the Individual in the
Social Sciences,” Schweizerische Zeitschrift für Volkswirtschaft und Statistik 112, 545–560.
Chapter 2 Economists’ View of Behavior 19
taxes, almost immediately accountants and financial planners begin developing clever ways to reduce their impact. Some self-employed individuals were able to re- duce the impact of recent tax increases by changing their status from a proprietorship to a corporation.
As another example, a 33-year-old Brazilian farm hand recently retired with full social security benefits after he satisfied social security auditors that he had been
ANALYZING MANAGERIAL DECISIONS: Marginal Analysis
You own a business that services trucks. A cus-
tomer would like to rent a truck from you for one
week, while you service his truck. You must decide
whether or not to do this.
You have an extra truck that you will not use for
any other purpose during this week. This truck is
leased for a full year from another company for
$300/week plus $.50 for every mile driven. You
also have paid an annual insurance premium, which
costs $50/week to insure the truck. The truck has a
full 100-gallon fuel tank.
The customer has offered you $600 to rent the
truck for a week. This price includes the 100 gal-
lons of fuel that is in the tank. It also includes up to
500 miles of driving. The customer will pay $.50
for each additional mile that he drives above the
500 miles. You anticipate that the customer will
bring back the truck with an empty fuel tank and
will have driven more than 500 miles. You sell fuel
to truckers at a retail price of $4.00/gallon. Any
fuel you sell or use can be replaced at a wholesale
price of $3.25/gallon.
The customer will rent a truck from another
company if you do not accept the proposed deal. In
either case, you will service his truck. You know
the customer and are confident that he will pay all
charges incurred under the agreement.
1. Should you accept or reject the proposed deal?
2. Would your answer change if your fuel sup-
plier limited the amount of fuel that you could
purchase from him at the wholesale price?
Explain.
M A N A G E R I A L A P P L I C AT I O N S
Creative Gaming of the System The U.S. Government in 2009 promoted the sales of presidential and Native American $1 coins by offering free
shipping on any order made to the U.S. Mint (which sold the coins at face value). Enthusiasts of frequent-flyer
mileage programs saw a creative way to “game” the government’s offer. Many credit cards are tied to the frequent-
flyer programs of major airlines—for every dollar charged on the card, a mile is credited to the relevant frequent-flyer
program. Several hundred “mile-junkies” responded by purchasing thousands of dollars worth of coins from the U.S.
Mint using their credit cards. Once they received the coins, they deposited the money in their bank accounts to pay
off their credit card charges before any interest costs were incurred. For example, Patricia Hansen, a San Diego retiree
who loves to travel, ordered $10,000 in coins earning 10,000 miles toward free and upgraded travel. Her husband
took the coins to the bank, as soon as they arrived, so that their credit card bill could be paid. The U.S. Mint
eventually figured out what was going on and stopped the program that had resulted in increased costs for them,
credit card companies, banks, and airlines. This example illustrates an important general point. People often respond to economic incentives in creative ways. Managers and government officials need to craft incentives thoughtfully.
Source: S. McCartney (2009), “Miles for Nothing: How the Government Helped Frequent Fliers Make a Mint,” The Wall Street Jour- nal (December 7), A1.
20 Part 1 Basic Concepts
working since he was three years old. Because Brazil doesn’t specify a minimum re- tirement age, the average Brazilian retires at age 49.8
Similarly, when hackers and corporate spies continue to develop more sophisticated schemes to steal information from Web sites or networks, software tools that detect break-ins also have grown in popularity and sophistication. This intrusion-detection soft- ware was about a $100 million industry in 1999 and is now estimated at over $2 billion.9
Understanding this creative nature of individuals has important managerial impli- cations that we discuss later in this chapter, as well as throughout the book.
Graphical Tools Economists often employ a set of graphical tools to illustrate how individuals make choices. These tools distinguish between the preferences (level of satisfaction) that the individual associates with each potential opportunity and the set of feasible op- portunities that an individual faces. We use these tools throughout this book. They also are used in other courses within the typical business school curriculum, such as in finance, human relations, and marketing courses. Our intent is to introduce these tools so that the reader is comfortable using them in basic business applications. We subsequently apply the tools to analyze the problems at Merrill Lynch. Appendix A provides a more detailed development of the economic theory of individual choice (commonly called the “Theory of Consumer Choice”).
Individual Objectives
Goods are things that people value. Goods include standard products like food and clothing, services like haircuts and education, as well as less tangible emotions such as love of family and charity. The economic model of behavior posits that people ac- quire goods that maximize their personal satisfaction, given their resource con- straints (such as a limited income). Economists traditionally use the term utility in re- ferring to personal satisfaction.
To provide a more detailed analysis of how people make choices, economists repre- sent an individual’s preferences by a utility function. This function expresses the rela- tion between total utility and the level of goods consumed. The individual’s objective is to maximize this function, given the resource constraints.10 This concept can be il- lustrated most conveniently through a simple example where an individual cares about only two goods. The insights from this two-good analysis can be extended readily to the case of additional goods such as food, housing, clothing, respect, and charity.
Suppose that Dominique Lalisse values only food and clothing. In general form, his utility function can be written as follows:
� �
Utility � F(Food, Clothing) (2.1)
8P. Fritsch (1999), “In Brazil Retirement Has Become a Benefit Nearly All Can Enjoy,” The Wall Street Journal (September 9), A1.
9J. D’Allegro (1999), “Intrusion Detection Matures,” National Underwriter (March 8), 9; and Frost and Sullivan (2007), “World Intrusion Detection and Prevention Markets,” www.frost.com
10Clearly, most individuals do not actually consider maximizing a mathematical function when they make
these choices. However, this formulation can provide useful insights into actual behavior to the extent that it
approximates how individuals make choices. Mathematicians have shown that if an individual’s behavior is consistent with some basic “axioms of choice” (comparability, transitivity, nonsatiation, and willingness to
substitute), the individual will make choices as if he or she were trying to maximize a mathematical function.
Chapter 2 Economists’ View of Behavior 21
Dom prefers more of each good—thus, his utility rises with both food and clothing. In Dom’s case, his specific utility function is
Utility � Food1�2 � Clothing1�2 (2.2)
For instance, if Dom has 16 units of food and 25 units of clothing, his total utility is 20 (that is, utility � 161�2 � 251�2 � 4 � 5 � 20). Dom is better off with 25 units of both food and clothing. Here, his utility is 25 (utility � 251�2 � 251�2 � 5 � 5 � 25).
Utility functions rank alternative bundles of food and clothing in the order of most preferred to least preferred, but they do not indicate how much one bundle is preferred to another. If the utility index is 100 for one combination of food and clothing and 200 for another, Dom will prefer the second combination. The second bundle does not nec- essarily make him twice as well off as the first bundle.11 Neither does this formulation allow one person’s utility of a bundle to be compared to another person’s utility.
Indifference Curves
Preferences implied by the utility function can be illustrated graphically through indifference curves. An indifference curve pictures all combinations of goods that yield the same utility. Given his utility function in Equation (2.2), Dom is indifferent between either 16 units of food and 25 units of clothing or 25 units of food and 16 units of clothing. Both combinations yield 20 units of utility, and hence are on the same indifference curve. Figure 2.1 shows two of Dom’s indifference curves. For example, if given a choice between any two points on curve 1, Dom would say that he does not care which one is selected—in either case, he obtains 8 units of utility.
Figure 2.1 Indifference Curves
These indifference curves picture all combinations of food and clothing that yield the same amount of utility. The specific utility function in this example is U � F 1�2 � C1�2, where F is food and C is clothing. Northeast movements are utility-increasing. Indifference curve 2 represents all combinations of food and clothing that yield 20 units of utility, whereas curve 1 pictures all combinations that yield 8 units of utility. Other indifference curves could be drawn for different levels of utility.
4 16 25 C
4
16
25
F
Quantity of clothing
Q u
a n
ti ty
o f
fo o
d
Increasing utility
1: U = 8
2: U = 20
11This is like rankings on a test—an individual who scores in the 80th percentile is not twice as smart as one
from the 40th.
22 Part 1 Basic Concepts
The slope at any point along one of Dom’s indifference curves indicates how much food he would be willing to give up for a small increase in clothing (his utility remains unchanged by this exchange).12 Standard indifference curves that illustrate trade-offs between two goods have negative slopes. If Dom obtains a smaller amount of one good such as clothing, the only way he can be equally as well off is to obtain more of another good like food. If at a point along an indifference curve the slope is 22, Dom is willing to give up 2 units of food to obtain 1 unit of clothing. Alterna- tively he is willing to give up 1�2 unit of clothing to obtain 1 unit of food. This willingness to substitute has important implications, which we discuss later.
Movements up and to the right in graphs like Figure 2.1 are utility-increasing. Holding the amount of food constant, utility increases by increasing clothing (a rightward movement). Holding the amount of clothing constant, utility increases by increasing the amount of food (an upward movement). Thus, in Figure 2.1, Dom would rather be on indifference curve 2 than on 1. He obtains 20 units of utility rather than 8.
Economists typically picture indifference curves as convex to the origin (they bow in, as in Figure 2.1). Convexity implies that if Dom has a relatively large amount of food, he would willingly exchange a relatively large quantity of food for a small amount of additional clothing. Thus, the indifference curves in Figure 2.1 are steep when the level of food is high relative to the level of clothing. In contrast, if he has a relatively large amount of clothing, he would be willing to substitute only a small amount of food for additional clothing. Correspondingly, the indifference curves in Figure 2.1 flatten as Dom has less food and more clothing. The behavior implied by the convexity of indifference curves is consistent with the observed behavior of many individuals—most people purchase balanced combinations of food and clothing.
Opportunities and Constraints
Dom would like more of both food and clothing. Unfortunately, he faces a budget constraint that limits his purchases. Suppose that he has an income of I and the prices per unit of food and clothing are Pf and Pc, respectively. In this single period analysis, we assume that Dom spends all his income on food and clothing. In a multiperiod context, Dom might want to save part of his income or borrow against future income. We examine these possibilities in Appendix B at the end of this chap- ter. Since he cannot spend more than I, his consumption opportunities are limited by the following constraint:
I � Pf F � PcC (2.3)
where F and C represent the units of food and clothing purchased. This budget con- straint indicates that only combinations of food and clothing that cost no more than I are feasible. Rearranging terms, this constraint can be written as
F � I�Pf � (Pc �Pf)C (2.4)
12Recall that the slope of a line is a measure of steepness, defined as the increase or decrease in height per unit
of distance along the horizontal axis. Slopes of curves are found geometrically by drawing a line tangent to
the curve at the point of interest and determining the slope of this tangent line. The slope at a point along one
of Dom’s indifference curves indicates how the quantity of food changes for small changes in the amount of
clothing in order to hold utility constant. Since by definition Dom is indifferent to this exchange (he remains
on the same indifference curve), he is willing to make the exchange.
Chapter 2 Economists’ View of Behavior 23
Figure 2.2 depicts these consumption opportunities—frequently called a budget line. All combinations of food and clothing on or below the line are attainable. Com- binations above the line are infeasible given an income of I. The F intercept (on the vertical axis) of the line I�Pf indicates how much food Dom can purchase if his en- tire income is spent on food (no clothing is purchased). The C intercept is corre- spondingly I�Pc. The slope of the line �Pc �Pf is �1 times the ratio of the two prices. The ratio Pc�Pf is the relative price of clothing in terms of food. It represents how many units of food he must forgo to acquire a unit of clothing: It is the oppor- tunity cost of clothing. For example, if the price of clothing is $8 and the price of food is $2, the relative price of clothing is 4. To keep total expenditures constant, 4 units of food must be given up for every unit of clothing purchased. The relative price of food is Pf �Pc (in this example, 0.25); 1�4 unit of clothing must be given up for each unit of food purchased.
The constraint changes with changes in Dom’s income and the relative prices of the two goods. As shown in Figure 2.3, changes in income result in parallel shifts of the constraint: Its slope is unaffected. An increase in income shifts the constraint out- ward (up and to the right), while a decrease in income shifts the constraint inward. The slope of the constraint changes with the relative prices of the two goods. As shown in Figure 2.4, if the price of clothing increases relative to the price of food, the constraint becomes steeper. If the price of clothing falls relative to the price of food, the constraint becomes flatter.
Individual Choice
Within this economic framework, Dom’s goal is to maximize utility given his op- portunities. Utility is maximized at the point of tangency between the constraint and
Figure 2.2 Opportunities and Constraints
The constraint reflects the feasible combinations of food and clothing that are attainable given the person’s income (I ). The vertical and horizontal intercepts, respectively, show the amounts of food and clothing that can be purchased if no income is spent on the other good. The slope of the constraint is equal to �1 times the ratio of the prices of the two goods. For instance, if the price of clothing is $8 and the price of food is $2, the slope will be �4. This slope implies that 4 units of food must be given up for 1 unit of clothing. If both goods have the same price, the slope will be �1.
I Pf
I Pc
C
Pf
Pc
F
Combinations above line are unaffordable
Combinations on/below line are affordable
Q u a n tit
y o f fo
o d
Quantity of clothing
–
24 Part 1 Basic Concepts
an indifference curve.13 Figure 2.5 portrays the optimal choice. Dom could choose points like b and c on indifference curve 1. However, point a on curve 2 yields greater satisfaction (utility) and thus is preferred. Dom would prefer to be at any point on curve 3. Yet, these points are unattainable given his income.
Figure 2.3 Income Changes
This figure shows that there is a parallel shift in the budget constraint when income changes. The slope of the constraint does not change because there is no change in the prices of the two goods. The slope is �1 times the ratio of the prices.
I Pc
I Pf
C
F
Lower income
Original consumption opportunities
Higher income
Quantity of clothing
Q u a
n tit
y o f fo
o d
IHI
Pc
ILO
Pc
Figure 2.4 Price Changes
This figure shows how his consumption opportunities change with changes in the price of clothing. The slope of the line is �(Pc�Pf). Thus, an increase in the price of clothing (from Pc to PcHI ) produces a steeper line, while a decrease (from Pc to PcLO) produces a flatter line. Changes in the price of food also affect the slope of the line.
C
I Pf
F
Increase in the price of clothing
Original consumption opportunities
Decrease in the price of clothing
Quantity of clothing
Q u a n tit
y o f fo
o d
I Pc
I Pc
LO I
Pc HI
13For simplicity, we ignore the possibility of corner solutions—the points where the budget constraint
intersects the axes. With corner solutions, the individual spends all income on only one good.
Chapter 2 Economists’ View of Behavior 25
This graphical solution to Dom’s choice problem has a simple intuitive interpre- tation. At the point of tangency, the indifference curve and the constraint have equal slopes. Recall that the slope of the indifference curve represents Dom’s willingness to trade food for clothing, whereas the slope of the constraint represents the terms of trade available in the marketplace. At the optimal choice, the willingness and ability to trade are equal. At other feasible combinations of food and clothing, Dom’s util- ity could be increased by making substitutions. For instance, if Dom were at a point where he was willing to trade 5 units of food for 1 unit of clothing and if the relative price of clothing were 4 units (the slope of the indifference curve is steeper than the constraint), Dom would be better off purchasing less food and more clothing. (He is willing to trade 5 units of food for 1 unit of clothing, but only must forgo 4 units of food to obtain 1 unit of clothing in the marketplace.) Alternatively, if Dom were at a point where he was only willing to forgo 1 unit of food for 1 unit of clothing (the slope of the indifference curve is flatter than the constraint), he would be better off purchasing more food and less clothing—since he receives 5 units of food for each unit of clothing forgone.
Earlier in this chapter, we discussed how marginal analysis is the cornerstone of modern economics. It is important to understand that the graphical tools presented in this section depict marginal analysis. In marginal analysis, individuals take actions as long as their incremental benefits are greater than their incremental costs. Our graphical analysis of individual choice corresponds to this decision rule. The relative price ratio, PC�PF, is the marginal cost of a unit of clothing, expressed as units of food—the units of food that are forgone is the opportunity cost of an additional unit of clothing. Similarly, the opportunity cost of an additional unit of food is PF�PC units of clothing. The slope of the indifference curve reflects the marginal benefit of an additional unit of clothing expressed as units of food. For example, if Dom is will- ing to trade 5 units of food for 1 unit of clothing (slope of the indifference curve � �5), his marginal benefit of one additional unit of clothing must equal the utility
Figure 2.5 Optimal Choice
The individual is best off by choosing point a where the constraint is tangent to indifference curve 2. This optimal combination of food and clothing, F * and C*, yields higher level of satisfaction (utility) than other feasible alternatives (e.g., points b and c). The individual would prefer points on indifference curve 3, but these points are infeasible given his consumption opportunities.
C *
F
F *
b
a
c 1
2
3
Quantity of clothing
Q u a n tit
y o f fo
o d
C
26 Part 1 Basic Concepts
from 5 units of food. Similarly, his marginal benefit of a unit of food is equivalent to .2 units (1�5) of clothing. If Dom is not at the point of tangency between the indif- ference curve and the budget line, the marginal benefit of trading one good for the other must be greater than the marginal cost. Suppose Dom is willing to trade 5 units of food for 1 unit of clothing, but only has to trade 2 units of food for 1 unit of cloth- ing in the marketplace. In this case, Dom should trade food for clothing since the marginal (incremental) benefit is greater than the marginal (incremental) cost. At the optimum (point of tangency) the marginal benefit of consuming 1 more unit of either good is equal to the marginal cost and there is no reason to make additional trades.
Changes in Choice
Dom’s consumption opportunities will change whenever prices or income change. Consequently, he will make different choices. Recall that changes in relative prices alter the slope of the constraint. When the relative price of a good increases, individ- uals typically choose less of that good.14 Figure 2.6 shows how Dom will purchase less food as its relative price increases—food is more expensive and so less attractive than it was at a lower price. Generally, the amount of clothing purchased can go either up or down; it depends on the location of the new tangency point. (Given the particular utility function assumed in this example, the amount of clothing purchased remains unchanged.) Even though the price of clothing is relatively more attractive, the increase in food prices can limit available income so as to reduce the amount purchased of both goods. Changes in Dom’s income cause parallel shifts in the
Figure 2.6 Optimal Choice and Price Changes
This figure shows how the optimal choice changes with an increase in the price of food. In this example, the individual chooses less food (F1* rather than F0*). This is the typical case—usually, an individual will purchase less of a good when its price increases. Due to the particular utility function used in this example, the amount of clothing purchased remains unchanged (C*). More generally, the amount of clothing purchased can go either up or down. It depends on the location of the new tangency point.
C * C
F
F0
Consumption opportunities after increase in price of food
Original consumption opportunities
Quantity of clothing
Q u a n tit
y o f fo
o d
*
F1*
14Although in principle some individuals might purchase more of a good if its price increases, this outcome is
rarely observed.
Chapter 2 Economists’ View of Behavior 27
constraint and will change his optimal choice. In Chapter 4, we examine in more detail how changes in income and prices affect consumption choices. Appendix A contains a more detailed analysis of the effects of price changes on individual choice and illustrates how this basic graphical analysis can be used to study inter-temporal choices, such as the choice between current consumption and savings.
Choices also change if preferences change. Now changes in preferences undoubt- edly occur. (Do you really believe that Toys ‘R’ Us will have any difficulty satisfying the demands for toys that were highly popular in past years, such as Teenage Mutant Ninja Turtle action figures, Tomaguchi virtual pets, Tickle-Me-Elmo dolls, or Poke- mon Cards next Christmas?) Yet, economists rarely focus on such explanations. Eco- nomics has little theory to explain what might cause preferences to change. And since a large premium is placed on operationalism in managerial economics, preference- based explanations generally are appealed to only after other potential explanations are exhausted. In a sense, these preference-based explanations are too easy—they work too well. Virtually any observed behavior could be explained by appealing to prefer- ences: Why did the consumption of frozen yogurt increase relative to that of ice cream? People’s preferences changed so that more frozen yogurt and less ice cream was demanded. But an observed reduction in consumption could have been “explained” just as readily. Without a deeper understanding of why preferences change, one is left “explaining” everything but with an analysis that allows you to predict nothing.
Ultimately, the managerial usefulness of this analysis comes from its power to identify policy instruments that have a predictable impact on the problems at hand. Across a broad array of problems, assuming that underlying preferences are reasonably stable and analyzing the impact of changes in opportunities and constraints regularly will yield important managerial insights and identify productive managerial tools.
ANALYZING MANAGERIAL DECISIONS: Consumer Choice and Graphical Tools
You are a manager for a company that bottles and
sells wine in two different countries. You charge
the same price for a bottle of wine in both coun-
tries. Yet, your wine sales are much higher in one
country than the other. Your boss asks you to de-
velop an explanation for the differences in wine
sales between the two countries and to develop a
plan to sell more wine in the country with low wine
consumption.
Population sizes and family incomes in the two
countries are very similar. You also know that each
country imposes a per bottle tax on wine. Begin by providing a plausible economic expla-
nation (focusing on constraints) for the differences
in wine sales in the two countries. Illustrate your
explanation by using indifference curves and bud-
get lines for representative consumers from the two
countries. What data would you want to determine
if your explanation is likely to be correct? Are there
other plausible explanations for the differences in
wine consumption? Are there ways to determine
which of these explanations is most likely to be dri-
ving the differences in consumption?
1. Suppose that your economic explanation is
likely to be correct and that your company will
not allow you to lower the price per liter that
you charge for wine in the two countries.
Discuss at least two potential actions that you
might take to sell more wine in the country
with low demand.
2. Now provide a potential preference-based ex- planation for the differences in wine sales.
Suppose that this explanation is correct. Dis-
cuss whether there are likely to be feasible
policies that you could use to increase wine
sales in the country with the low demand.
28 Part 1 Basic Concepts
Motivating Honesty at Merrill Lynch Often, economists focus on consumption goods such as food and clothing. This focus is natural given the interests economists have in understanding consumer behavior. Yet this analysis can be extended easily to consider other goods that people care about, such as love and respect.15 Such an extension can be used to analyze the problem at Merrill Lynch.
Suppose that Susan Chen, like other analysts at Merrill Lynch, values two goods—money and integrity. Her utility function is
� � Utility � F (Money, Integrity) (2.5)
Money is meant to symbolize general purchasing power; it allows the purchase of goods such as food, clothing, and housing. Integrity is something Sue values for its own sake—being honest in her dealings with other people provides Sue with satis- faction and she values it for that reason.
Suppose that integrity can be measured on a numerical scale with Sue preferring higher values. For example, 5 units of integrity provide more utility than 4 units of integrity. (In actuality, measuring a good like integrity on a numerical scale might be quite difficult. Yet this complication does not limit the qualitative insights that we can derive from the analysis.)
Merrill paid its stock analysts an annual bonus that was based partly on the ana- lyst’s contribution to the investment banking side of the business (e.g., the firm’s un- derwriting activities). If Sue were completely honest and rated a company as a poor investment, the management of that company might take its investment banking business to another firm. The resulting loss in Merrill’s investment banking revenue would reduce Sue’s annual bonus. This bonus scheme thus confronts Sue with a trade-off. She can be honest and derive satisfaction from maintaining her integrity, or she can be dishonest in her rating of the stock and obtain a higher bonus. (She also might consider the future effects on her income from developing a good or bad rep- utation as an investment analyst. However, the analysis in this chapter is framed in a simple one-period context and does not consider monetary returns from developing a good reputation. In subsequent chapters we extend the analysis and consider such multiperiod effects.)
Figure 2.7 depicts Sue’s implied opportunities. This constraint shows the maxi- mum combinations of income and integrity that are feasible given the compensa- tion plan and conditions at the company.16 If Sue sacrifices all integrity, she earns $max a year. If she is scrupulously honest in her investment recommendations, she earns less (there is a positive floor on her income, $min, since her base salary does depend on the amount of investment banking business and her analysis undoubt- edly will suggest recommending some of Merrill’s clients’ stocks). Intermediate options along the constraint are possible. While Sue would like to earn more than $max, higher income is not feasible in this job.
15G. Becker (1993), “Nobel Lecture: The Economic Way of Looking at Behavior,” Journal of Political Economy 101, 385–409.
16For simplicity, we draw the constraint as linear. Linearity is not necessary for our analysis. Also, we want to
emphasize that we put dollars on the vertical axis only because it is a convenient general indication of value,
not because money is more important than other things. We could illustrate Sue’s willingness to trade
integrity against anything else Sue values, such as Big Macs, pianos, or pairs of jeans.
Chapter 2 Economists’ View of Behavior 29
Sue chooses the combination of integrity and income that places her on the high- est attainable indifference curve. This choice occurs at the point of tangency between her indifference curve and the constraint. Sue ends up selecting relatively low amounts of integrity because the bonus plan adopted by Merrill’s management has made integrity expensive. If Sue were to choose more integrity, she would forfeit a relatively large amount of income.
Management can alter the opportunities Sue and her colleagues face by chang- ing its compensation plan. In the Merrill case, reducing the emphasis of investment banking revenue in determining the annual bonus reduces the gains from dishonest advice and thus flattens the constraint. Changes in the slope of the constraint result in a different tangency point and hence a different choice. Figure 2.8 shows how Sue’s optimal choice changes when the emphasis on investment banking revenue is decreased.17 The result is more honest behavior. In essence, Sue “purchases” more integrity because it now is less expensive. Consistent with this analysis, Merrill, in its settlement with the State of New York, agreed to change the way it evaluated and compensated its analysts. Bonuses now are based on the quality of investment advice—not tied to its investment banking business.
Figure 2.7 Nature of Opportunities Facing an Analyst at Merrill Lynch
The constraint depicts the maximum amounts of money and integrity that are possible for the analyst given the bonus plan and conditions at the company. If the analyst sacrifices all integrity and recommends stocks even if they are poor investments, the employee earns a maximum of $max a year. Investment banking business is lost if the analyst gives objective advice and rates certain stocks as poor investments (selects a higher level of integrity). Income is lower since the analyst is paid a bonus based on investment banking revenues. Ic represents complete honesty. Ic
I
$
$max
$min
Quantity of integrity
In co
m e (
in d
o lla
rs )
17We have altered the compensation scheme in a manner that places Sue on the same indifference curve. Our
rationale for doing this is as follows: Merrill Lynch must provide Sue with sufficient job satisfaction
(utility) to retain her at the firm. Below this level of utility, Sue will quit and work elsewhere. Merrill Lynch
is unlikely to want to pay Sue more than this minimum utility because it reduces firm profits. Thus, Merrill
Lynch has an incentive to adjust compensation in a manner that keeps her on the same indifference curve.
Sue’s indifference curve in Figure 2.8 can be viewed as this “reservation” utility. These issues are covered
in more detail in Chapter 14.
30 Part 1 Basic Concepts
Managerial Implications This analysis illustrates how the economic framework can be used to analyze and ad- dress management problems. Managers are interested in affecting the behavior of in- dividuals such as employees, customers, union leaders, or subcontractors. Under- standing what motivates individuals is critical. The economic approach views individual actions as the outcomes of maximizing personal utility. People are willing to make substitutions (e.g., less leisure time for more income) so long as the terms of trade are advantageous. Managers can affect behavior by appropriately designing the opportunities facing individuals. The design of the opportunities affects the trade- offs that individuals face and hence their choices. For example, management can mo- tivate employees through the structure of compensation plans or customers through pricing decisions.
The outcome of individuals making economic choices is a function of both op- portunities and preferences. Individuals try to achieve their highest level of satisfac- tion given the constraints they face. Our discussion of management implications, however, intentionally focuses on opportunities and constraints, not preferences. As a management tool, the usefulness of focusing on personal preferences often is lim- ited. It is difficult to change what a person likes or does not like. Moreover, prefer- ences rarely are observable, and (as we noted earlier) virtually any observed change in choice can be “explained” as simply a matter of a change in personal tastes. For instance, a preference-based explanation as to why employees were dishonest at Merrill Lynch is that these employees gained personal satisfaction from being dishonest (or compared to employees at other firms, Merrill Lynch employees were willing to trade large amounts of personal integrity for small financial rewards). This
Figure 2.8 Optimal Choices of an Analyst at Merrill Lynch under Two Different Compensation Plans
Case 1 reflects the original compensation plan. In this case, compensation includes a high bonus based on investment banking revenues and the constraint is relatively steep. In Case 2, the firm reduces the emphasis on investment banking revenues in compensating analysts. The slope of the constraint is flatter. The result is that the individual chooses a higher level of integrity in Case 2 than in Case 1.
$
$1*
I1* I2*
Case 2
Case 1 I
In co
m e (
in d
o lla
rs )
Quantity of integrity
$2*
Chapter 2 Economists’ View of Behavior 31
explanation is not very helpful in giving management guidance on how to address the problem. It suggests that Merrill Lynch might try to fire dishonest employees and replace them with employees who care more about personal integrity. But the diffi- culty of observing personal preferences limits the feasibility of this approach. It would be difficult for Merrill Lynch to know if, as a group, its new hires would be any less dishonest than the old employees. You cannot just ask applicants if they are honest—if they are not, they will have no qualms about claiming that they are.
The fact that individuals are clever and creative in limiting the effects of con- straints greatly complicates management problems. Changing incentives will affect employee behavior, though sometimes in a perverse and unintended manner. Con- sider two of the Soviet Union’s early attempts to adopt incentive compensation to motivate employees. To discourage taxi drivers from simply parking their cabs, they were rewarded for total miles traveled; to encourage additional production, chande- lier manufacturers were rewarded on total volume of production—measured in kilo- grams. In response to these incentive plans, Moscow taxi drivers began driving empty cabs at high speeds on highways outside the city and chandelier manufactur- ers started producing such massive fixtures that they literally would collapse ceil- ings. (It is less costly to make one 100-kilo chandelier than five 20-kilo chandeliers; manufacturers also substituted lead for lighter-weight inputs.) Merrill Lynch initially adopted bonuses to motivate analysts to work harder and cooperate across business units. The deceitful behavior was a side effect that potentially was unanticipated when the plan was adopted.
In summary, the economic approach to behavior has important managerial impli- cations. The framework suggests that a manager can motivate desired actions by es- tablishing appropriate incentives. However, managers must be careful because set- ting improper incentives can motivate perverse behavior.
It is worth noting that economic analysis is limited in its ability to forecast the pre- cise choices of a given individual because individual preferences are largely unob- servable. The focus is on aggregate behavior or on what the typical person tends to do. For example, an economist might not be very good at predicting the responses of individual employees to a new incentive plan. An economist will be successful in
M A N A G E R I A L A P P L I C AT I O N S
More to Life than Money Should you hire a housekeeper or clean your house yourself? Should you mow your own lawn or hire the kid next door?
People confront these types of questions everyday. Spending money on housekeepers, gardeners, etc. provides extra time
to use for other activities, but it comes at the cost of having less money to purchase other things. People vary in their
attitudes when it comes to time versus money. In a recent survey conducted by LearnVest and Chase Blueprint,
54 percent said they would like more money rather than more time, while 46 percent they want more free time relative to
more money. It is not uncommon to see people in well paid positions retiring early to spend more time with family or to
pursue other personal interests. For example, Kelly Malson was the CFO of World Acceptance Corp. and had an annual
pay package valued at $4.8 million in 2013. During the summer of 2013, one of her college friends died of Lou Gehrig’s
disease at 46. Kelly, who was only 43, decided to quit her job to pursue her dreams while she still could, which included
traveling to all 50 U.S. states and pursuing a graduate degree. Kelly, as well as most other people, clearly value things
other than just money and regularly make choices that trade off money for other things that they value.
Source: C. Oakley (2013), “Would You Rather Have More Time or More Money?” Forbes (12/20) and M. Murphy (2013), “More CFOs Choose to Retire Early,” The Wall Street Journal (December 10).
32 Part 1 Basic Concepts
predicting that the typical employee will work harder—and thus output for the group will rise—when compensation is tied to output, than when a fixed salary indepen- dent of performance is paid. Managers typically are interested in structuring an or- ganizational architecture that will work well and does not depend on specific people filling particular jobs. Individuals come and go, and the manager wants an organiza- tion that will work well as these changes occur. In this context, the economic frame- work is likely to be useful. To solve management problems where the characteristics of a specific individual are more important, other frameworks may be more valuable. For example, if the board is interviewing a potential new CEO, insights into that in- dividual’s behavior derived from psychology might be extremely useful.
Alternative Models of Behavior18
We have shown how the economic view of behavior can be used in managerial deci- sion making. We now discuss four other models that are commonly used by man- agers (either explicitly or implicitly) to explain behavior. Our discussion of each of these models is simplified. The intent, however, is to capture the essence of a few of the more prominent views that managers have about behavior and to illustrate how managerial decision making is affected by the particular view. We contrast these
M A N A G E R I A L A P P L I C AT I O N S
Medicare Creates Perverse Incentives for Doctors Doctors do not care about money but are motivated by concerns about providing the best care for patients—right?
Apparently many doctors and the major drug company employees do not think so. Perverse incentives among
physicians arguably have contributed to the problem of spiraling health care costs in the United States.
For years, Medicare (federal health program for the elderly) reimbursement policies allowed individual doctors to
make hundreds of thousands of dollars a year in extra profits from the drugs they administered to patients in their
offices (the doctors would buy the drugs themselves and bill Medicare, rather than having the patients get them directly
from pharmacies). For example, many cancer doctors earned over $1 million per year on drug sales alone. Because the
profits on different drugs varied enormously, doctors had incentives to prescribe medications with the highest profit
margins. Some physicians have acknowledged that they performed treatments that got them the best reimbursements,
“whether or not the treatments benefited patients.”
Drug companies were well aware of the Medicare policies and calculated the profits that doctors received from
prescribing specific drugs “down to the penny.” For example, in 1998 Schering-Plough told its sales representatives
that its drug for the treatment of bladder cancer could produce a profit for a physician of $2,373.84 per patient. Sales
representatives in turn made sure that doctors were well aware when their drugs were in the high-profit category. For
instance, a sales representative for AstraZeneca wrote in a letter to Arizona urologists, “DO THE MATH.”
Medicare changed its reimbursement policies in 2005 and reduced the profits that physicians could make on drug
sales. At least some physicians have responded by shifting from drug intensive treatments to other treatments that have
higher profit margins. To quote one doctor, “People go where the money is, and you’d like to believe it’s different in
medicine, but it’s really no different . . . as long as oncologists continue to be paid by the procedure instead of spending
time with patients, they will find ways to game the system.”
Source: A. Berensen (2007), “Incentives to Limit Any Savings in Treating Cancer,” nytimes.com (June 12).
18This section draws on W. Meckling (1976).
Chapter 2 Economists’ View of Behavior 33
alternative views with the economic view and argue why the economic framework is a particularly useful tool for managers.
Only-Money-Matters Model
Some people believe that the only important component of the job is the level of monetary compensation. But as we have already suggested, people have an incredi- bly broad range of interests, extending substantially beyond money. And these inter- ests are reflected in a diverse array of activities. As examples, much of the work through the Red Cross is undertaken by unpaid volunteers; people frequently choose early retirement, forgoing a regular paycheck to enjoy additional leisure time; riskier occupations command higher pay in order to attract people into those jobs.
Some of this confusion can result from a misinterpretation of standard economic analysis. Central to economics is the study of trade-offs (recall our discussion of in- difference curves illustrating trade-offs between food and clothing). Economists fre- quently use money as one of the goods being considered. But in these cases, money is merely a convenient unit of value: It simply represents general purchasing power. Its use does not suggest that only money matters.
Happy-Is-Productive Model
Managers sometimes assert that happy employees are more productive than un- happy employees. Managers following this happy-is-productive model see as their goal the designing of work environments that satisfy employees. Psycholog- ical theories, such as Maslow’s and Herzberg’s, are frequently used as guides in ef- forts to increase job satisfaction.19
M A N A G E R I A L A P P L I C AT I O N S
Happy Is Productive versus Economic Incentives—The Affordable Care Act The Affordable Care Act, better known, as “ObamaCare,” has generated significant controversy since it was signed into
law in 2010. The Congressional Budget Office (CBO) conducts economic analysis for Congress and is “widely revered
by both Democrats and Republicans alike as the gold standard for economic analysis.” In 2014, the CBO reported that
it expected the equivalent of 2.5 million Americans, who were otherwise willing and able to work before ObamaCare,
to work less or not at all as a result of the law by 2024. The projection contrasts dramatically with earlier forecasts
made by proponents of ObamaCare, who projected a resulting increase in employment. These positive forecasts were
based in part on an implicit assumption of the Happy is Productive Model of Behavior. The logic is as follows. Most
people want to work because being productive leads to greater happiness. Bad health, however, can prevent people
from working. ObamaCare by promoting a healthier population will increase the number of employed people. This
argument, however, ignores economic incentives. ObamaCare imposes a stiff economic cost on unemployed people
who take jobs—they lose all or part of their government subsidies for purchasing health insurance. Economist Casey
Mulligan sums up the economic incentives created by ObamaCare succinctly, “when you pay people for being low
income, you are going to have more low-income people.” While this is but one effect in evaluating the merits of
ObamaCare, it would appear to be a potentially important one.
Source: J. Rago (2014), “The Weekend Interview with Casey Mulligan,” The Wall Street Journal (February 8), A15.
19F. Herzberg, B. Mausner, and B. Snyderman (1959), The Motivation to Work (John Wiley & Sons: New York); and A. Maslow (1970), Motivation and Personality (Harper & Row: New York).
34 Part 1 Basic Concepts
A manager adhering to the happy-is-productive model might suggest that the problem at Merrill Lynch was motivated by disgruntled employees who took out their frustrations on customers. This view implies that Merrill Lynch could reduce the problem by promoting employee satisfaction through such actions as designing more interesting jobs, increasing the rates of pay, and improving the work environ- ment. Happier employees would be expected to provide customers with better in- vestment advice.
The economic and happy-is-productive models do not differ based on what peo- ple care about. The economic model allows individuals to value love, esteem, inter- esting work, and pleasant work environments, as well as more standard economic goods such as food, clothing, and shelter. The primary difference in the models is what motivates individual actions. In the happy-is-productive model, employees exert high effort when they are happy. In the economic model, employees exert effort because of the rewards.
To contrast the two models, consider offering an employee guaranteed lifetime employment plus a large salary, which will be paid independent of performance. The happy-is-productive model suggests that the employee will be more productive, because the high salary and job security are likely to increase job satisfaction. The economic model suggests that the employee would exert less effort—since the em- ployee receives no additional rewards for working harder and will not be fired for ex- erting low effort.
Good-Citizen Model
Some managers subscribe to the good-citizen model. The basic assumption is that employees have a strong personal desire to do a good job; they take pride in their work and want to excel. Under this view, managers have three primary roles. First, they need to communicate the goals and objectives of the organization to employees. Second, they must help employees discover how to achieve these goals and objec- tives. Finally, managers should provide feedback on performance so that employees can continue to improve their efforts. There is no reason to have incentive pay, since individuals are interested intrinsically in doing a good job.
M A N A G E R I A L A P P L I C AT I O N S
Culture and Behavior In Tokyo, lost cell phones, umbrellas, and cash regularly find their way to the Tokyo Metropolitan Police Lost and
Found Center—the Japanese are scrupulous about turning in found articles. In 2002 the center handled $23 million in
cash and 330,000 umbrellas. Scrupulous behavior of this type is far less common in New York City and many other
cities around the world. What accounts for this “cultural difference?” The historic and current behavior of the Japanese
can be explained at least in part by economic incentives.
The system traces its roots to a code written in 718. Lost goods, animals, and servants had to be handed over to a
government official within five days of being found. Not handing over found objects was severely punished. In 1733
two officials who kept a parcel of clothing were led around town and executed. Current law gives the finder seven days
to turn in found goods. If the item is reclaimed, the finder is entitled to a reward (5 to 20 percent). If the item is not
reclaimed within six months, the finder can claim it.
The most commonly reclaimed item is a cell phone—about 75 percent are returned. The least reclaimed are
umbrellas at 0.3 percent.
Source: N. Onishi (2004), “Never Lost, but Found Daily,” New York Times (January 8), A1.
Chapter 2 Economists’ View of Behavior 35
This view suggests that the problems at Merrill Lynch occurred because employ- ees misunderstood what was good for the company. Employees might have thought that increasing investment banking revenues was in the company’s best interests, even if it required a certain amount of dishonesty. Under the good-citizen view, the management of Merrill Lynch could motivate employee honesty by clearly commu- nicating to its analysts that Merrill Lynch would be better off in the long run if they did not deceive their customers. Managers might be instructed to hold a series of an- alyst meetings to stress the value of honesty and objective investment advice.
In the good-citizen model, employees place the interests of the company first. There is never a conflict between an employee’s personal interest and the interest of the company. In contrast, the economic model posits that employees maximize their own utility. Potential conflicts of interest often arise. The economic view predicts that pleas from Merrill Lynch management that analysts be more honest would have little effect on behavior unless they also changed the reward system to make it in the interests of analysts to be more honest.
Product-of-the-Environment Model
The product-of-the-environment model argues that the behaviors of individuals are largely determined by their upbringings. Some cultures and households encourage positive values in individuals, such as industry and integrity, whereas others promote negative traits, such as laziness and dishonesty. This model suggests that Merrill Lynch had dishonest analysts. A response would have been to fire these employees and replace them with honest analysts from better backgrounds.
Which Model Should Managers Use? Behavior is a complex topic. No behavioral model is likely to be useful in all con- texts. For example, the economic model is unlikely to be helpful in predicting whether a given individual will prefer a red shirt to a blue shirt (selling at the same price). But our focus is on managerial decision making. In this context, there are rea- sons to believe that the economic model is particularly useful.
Managers are frequently interested in fostering changes in behavior. For example, managers want consumers to buy more of their products, employees to exert more effort, and labor unions to accept smaller wage increases. In contrast to other mod- els, the economic framework provides managers with concrete guidance on how to alter behavior. Desired behavior can be encouraged by changing the feasible oppor- tunities facing the decision maker. For example, incentive compensation can be used to motivate employees, and price changes can be used to affect consumer behavior.
There is ample evidence to support the hypothesis that this economic framework is useful in explaining changes in behavior. The most common example is that con- sumers tend to buy less of a product at higher prices. The evidence suggests that the model is also useful in explaining aspects of behavior in many other contexts, in- cluding voting; the formation, dissolution, and structure of families; drug addiction; and the incidence of crime.20
20G. Becker (1993).
36 Part 1 Basic Concepts
The good-citizen model appears less successful in predicting behavior in busi- ness settings. Management would be an easy task if employees would work harder and produce higher-quality products simply on request. The happy-is-productive model also has material limitations. Most importantly, the existing evidence sug- gests that there is little relation between job satisfaction and performance (see Scott’s “Criticisms of the Happy-Is-Productive Model” in the accompanying box). Happy employees are not necessarily more productive. Sometimes, managers might want to follow the implications of the product-of-the-environment model and fire employees with undesirable traits. Yet, this approach is of limited use in solving most managerial problems. Also, given laws that limit discrimination, this approach can subject the firm to potentially serious legal sanctions.
The Economic Framework and Criminal Behavior Criminals often are viewed as psychologically disturbed. Evidence, however, suggests that criminal behavior can be
explained, at least in part, by the economic framework. This framework predicts that a criminal will consider the
marginal costs and benefits of a crime and will commit the crime only when the benefits exceed the costs. Under this
view, increasing the likelihood of detection and/or the severity of punishment will reduce crimes. In a pioneering study,
Issac Ehrlich examined whether the incidence of major felonies varied across states with the expected punishment. He
found that the incidence of robberies decreased about 1.3 percent in response to each 1 percent increase in the
proportionate likelihood of punishment. The incidence of crime also decreased with the severity of the punishment.
Since Ehrlich’s study, scholars have conducted extensive research on this topic. In general, the results support the
conclusion that the economic model plays a useful role in explaining criminal activity.
Source: I. Ehrlich (1973), “Participation in Illegitimate Activities: A Theoretical and Empirical Investigation,” Journal of Political Economy 81, 521–565.
A C A D E M I C A P P L I C AT I O N S
Criticisms of the Happy-Is-Productive Model W. Richard Scott summarizes some of the major concerns about the happy-is-productive model (sometimes referred to
as the human-relations movement):
Virtually all of these applications of the human-relations movement have come under severe criticism on both ideological and empirical grounds. Paradoxically, the human-relations movement, ostensibly developed to humanize the cold and calculating rationality of the factory and shop, rapidly came under attack on the grounds that it represented simply a more subtle and refined form of exploitation. Critics charged that workers’ legitimate economic interests were being inappropriately deemphasized; actual conflicts of interest were denied and “therapeutically” managed; and the roles attributed to managers represented a new brand of elitism. The entire movement was branded as “cow sociology” just as contented cows were alleged to produce more milk, satisfied workers were expected to produce more output.
The ideological criticisms were the first to erupt, but reservations raised by researchers on the basis of empirical
evidence may in the long run prove to be more devastating. Several decades of research have documented no clear
relation between worker satisfaction and productivity.
Source: W. R. Scott (1981), Organizations: Rational, Natural and Open Systems (Prentice Hall: Englewood Cliffs), 89–90.
A C A D E M I C A P P L I C AT I O N S
Chapter 2 Economists’ View of Behavior 37
Behavioral Economics The traditional economic model of behavior assumes that individuals are rational, in that they employ marginal analysis in decision making—they balance the incremen- tal costs and benefits to arrive at choices that maximize their personal happiness. One, however, does not have to look far to observe people making choices that by this def- inition appear economically irrational. For example, how many of us have eaten all the food served on a plate, even when we are not hungry and want to lose weight? Do we have some vague notion that we are not wasting food by eating more than we re- ally need or want? How many of us might volunteer to help a distressed person change a flat tire for free, but feel insulted if they offered to pay us for the work?
Simple behavioral observations, as well as more formal evidence from experiments, suggest that people do not always behave rationally. A somewhat new field called Behavioral Economics has emerged that covers a wide range of attempts to extend the standard economics framework to account for potentially relevant features of human behavior that are not included in standard analysis21. While
ANALYZING MANAGERIAL DECISIONS: Interwest Healthcare Corp.
Interwest Healthcare is a nonprofit organization
that owns 10 hospitals located in three western
states. Cynthia Manzoni is Interwest’s CEO. Vijay
Singh, Interwest’s CFO, and the administrators of
the 10 hospitals report to Manzoni.
Singh is deeply concerned because the hospital
staffs are not being careful when entering data into
the firm’s management information system. This
data involves information on patient intake, treat-
ment, and release. The information system is used
to compile management reports such as those relat-
ing to the costs of various treatments. Also, the sys-
tem is used to compile reports that are required by
the federal government under various grant pro-
grams. Singh reasons that without good informa-
tion, the management and government reports are
less useful and potentially misleading. Moreover,
the federal government periodically audits Inter-
west and might discontinue aid if the reports are
deemed inaccurate. Thus, Singh is worried about
the managerial implications and the potential loss
of federal funds.
Singh has convinced Manzoni that a problem
exists. She also realizes the importance of an accu-
rate system for both management planning and
maintaining federal aid. Six months ago, she invited
the hospital administrators and staff members from
the corporate financial office to a retreat at a resort.
The purpose was to communicate to the hospital ad-
ministrators the problems with the data entry and to
stress the importance of doing a better job. The
meeting was acrimonious. The hospital people ac-
cused Singh of being a bureaucrat who did not care
about patient services. Singh accused the hospital
staffs of not understanding the importance of accu-
rate reporting. By the end of the meeting, Manzoni
thought that she had a commitment by the hospital
administrators to increase the accuracy of data entry
at their hospitals. However, six months later, Singh
claims that the problem is as bad as ever.
Manzoni has hired you as a consultant to ana-
lyze the problem and to make recommendations
that might improve the situation.
1. What are the potential sources of the problem?
2. What information would you want to analyze?
3. What actions might you recommend to in-
crease the accuracy of the data entry?
4. How does your view of behavior affect how
you might address this consulting assignment?
21See Behavioral Economics and Its Application (2007), edited by P. Diamond and H. Vartiainen (Princeton University Press, Princeton and Oxford) for a collection of papers that summarize behavioral research on a
variety of economic topics.
38 Part 1 Basic Concepts
behavioral economists do not argue that economic incentives are unimportant, they tend to focus more on the cognitive, emotional, and social factors that affect individ- uals in making economic decisions. The ultimate objective of this research is to provide a better understanding of both aggregate market and individual economic behavior than we can get from the standard analysis alone.
The assumptions used in any type of scientific modeling, however, are never en- tirely realistic. Indeed, the purpose of a model is to simplify the analysis to make it tractable. For instance, a physical scientist might assume “unrealistically” that there is a perfect vacuum to derive a scientific formula. The test of her model, however, should not be based on the realism of her assumptions, but on how well the model helps us to predict or understand real-world phenomena. By this criterion, standard economic analysis has stood the test of time. For many decades, it has proven useful in helping managers to understand their competitive environments better and for im- proving their decision making and performance. This book presents the standard economic framework and focuses on the many managerial insights that it provides. A detailed study of Behavioral Economics, while potentially interesting, is beyond the scope of this book.
The need for more “realistic” assumptions in a model depends in part on the pur- pose of the model. For example, suppose that your boss has to go to Chicago for a business meeting and wants you to provide directions on how to drive to the specific location. You have at least two choices: (1) you might download a satellite photo- graph of the Chicago area or (2) you might get a map. Although the satellite photo would certainly include more realism, for this purpose, the map would be more useful. Most of the additional realism in the photograph is extraneous for your par- ticular purpose. The map abstracts from these unimportant aspects of the area to highlight those facets that are important. It is precisely this sense in which within this book, we employ models that abstract from an array of aspects of reality to high- light those things that are important for the particular issue at hand. On a few occa- sions, particularly in the chapters on organizational architecture, we analyze issues for which behavioral economics provides particularly relevant insights for managers. In these cases, we present both the standard economic analysis of the problem, as well as discussion of the implications from the behavior research.
Decision Making under Uncertainty Throughout this chapter, we have considered cases where the decision maker has complete certainty about the items of choice. For instance, Dom Lalisse knew the exact prices of food and clothing, and Sue Chen knew the precise trade-off between integrity and compensation at Merrill Lynch. Decision makers, however, often face uncertainty. For instance, in choosing among risky investment alternatives (such as stocks and bonds), an individual must forecast the likely payoffs. Even so, there can be significant uncertainty about the eventual outcomes. The analysis presented in this chapter can be extended readily to incorporate decision making under uncer- tainty.22 A detailed analysis of decision making under uncertainty is beyond the scope of this book. This section introduces a few key concepts that we will use later in this book.
22For example, E. Fama and M. Miller (1972), The Theory of Finance (Dryden Press: New York), Chapter 5.
Chapter 2 Economists’ View of Behavior 39
Expected Value
Taylor McClure sells real estate for RealCo. He receives a sales commission from his employer. For simplicity, suppose that Taylor has three possible incomes for the year. In a good year, he sells many houses and earns $200,000, whereas in a bad year he earns nothing. In other years, he receives $100,000. Probability refers to the likeli- hood that an outcome will occur. In this example, each outcome is equally likely, and thus has a probability of 1�3 of occurring. The expected value of an uncertain payoff is defined as the weighted average of all possible outcomes, where the probability of each outcome is used as the weights. The expected value is a measure of central tendency—the payoff that will occur on average. In our example, the expected value is23
Expected value � (1�3 � 0) � (1�3 � 100,000) � (1�3 � 200,000) (2.6) � $100,000
Variability
Although Taylor can expect average earnings of $100,000, his income is not certain. The variance is a measure of the variability of the payoff. It is defined as the ex- pected value of the squared difference between each possible payoff and the ex- pected value. In this example, the variance is
Variance � 1�3(0 � 100,000)2 � 1�3(100,000 � 100,000)2 (2.7) �1�3(200,000 � 100,000)2
� 6.7 billion
The standard deviation is the square root of the variance:
Standard deviation � (6.7 billion)1�2 � $81,650 (2.8)
Variances and standard deviations are used as measures of risk. It does not really mat- ter which we use, since one is a simple transformation of the other (higher standard de- viations correspond to higher variances). In this example, we focus on the standard deviation—in part because the standard deviation is expressed in the same units as the mean, dollars (the units for the variance would be dollars squared). Higher standard deviations reflect more risk. An event with a definite outcome has a standard deviation of zero.
Risk Aversion
Like most people, Taylor is risk-averse: Holding the expected payoff fixed, he prefers a lower standard deviation. He, therefore, gains utility from an increase in expected value, but he experiences a reduction in utility from increases in standard deviation. Figure 2.9 shows three of Taylor’s indifference curves. Each curve shows all combinations of expected value and standard deviation that give Taylor equal
23Note that the expected value need not equal one of the possible outcomes. As a weighted average, it can be
a value between outcomes. In this example, it happens to correspond to one of the possible outcomes,
$100,000.
40 Part 1 Basic Concepts
utility. In contrast to our previous analysis, here one of the objects of choice is a “bad”—Taylor dislikes risk. Thus, in this figure, the indifference curves have posi- tive slopes, and upward and leftward movements are utility-increasing (recall in the standard analysis that the curves have negative slopes, and upward and rightward movements are utility-increasing). The slopes of the indifference curves indicate Taylor’s degree of risk aversion. Steeper slopes translate into higher risk aversion. (If the slopes of the indifference curves are steep, Taylor must receive a relatively large increase in expected value for each additional unit of risk to maintain a con- stant level of utility.) If his indifference curves were totally flat, he would be risk- neutral. A risk-neutral person cares only about expected value and is indifferent to the amount of risk. Indifference curve 3 is associated with the highest level of util- ity, whereas curve 1 is associated with the lowest utility. Taylor is currently on curve 2. Given a choice among compensation plans with different expected payoffs and risk, Taylor will choose the combination that places him on the highest attain- able indifference curve.
Certainty Equivalent and Risk Premium
Figure 2.9 indicates that Taylor is indifferent between the risky commission scheme, which has an expected payoff of $100,000, and a certain income of $80,000. The $80,000 is Taylor’s certainty equivalent for the risky income stream—he is willing to trade the uncertain income of $100,000 for a certain income of $80,000. The dif- ference between the expected value of the risky income stream and the certainty equivalent is called the risk premium. This $20,000 premium, which comes in the form of a higher expected payoff, must be paid to keep Taylor indifferent between the risky income stream and his certainty equivalent.
Figure 2.9 Indifference Curves for Expected Value and Standard Deviation
This figure displays three indifference curves for a risk-averse individual. The individual prefers higher expected value but lower standard deviation. Standard deviation is a measure of risk. Since risk is a “bad,” the indifference curves are positively sloped. Upward and leftward moves are utility-increasing. Currently, the individual has a compensation package that has an expected value of $100,000 and a standard deviation of $81,650. The certainty equivalent of this package is $80,000. The risk premium is $20,000.
$
E xp
e ct
e d v
a lu
e (
in d
o lla
rs )
3
2
1 Risk premium = $20,000
Standard deviation (in dollars)
81,650
80,000
100,000
Increasing utility
$
Chapter 2 Economists’ View of Behavior 41
Suppose that Taylor receives a job offer from a competing real estate company that would pay him a fixed salary of $90,000 per year. Taylor considers the new job to be the same as his current job in all dimensions other than the compensation plan. Taylor’s current compensation plan will not be sufficient to motivate him to continue to work for RealCo. Even though his current plan has a higher expected payoff, he would prefer the certain $90,000 to RealCo’s risky commission plan. If RealCo wants to retain Taylor, it must offer him a compensation package that provides the same level of utility as the $90,000 for certain.
Risk Aversion and Compensation
Diversified shareholders, who invest in portfolios of companies, own much of the stock of large firms. Managers are often ill-diversified, having much of their human and financial capital invested in one firm. As we will discuss later in this book, this difference in diversification can lead to managers being overly risk averse in their investment decisions relative to those shareholders would prefer. Shareholders can induce managers to undertake more risky investment by adopting compensation plans that reward good outcomes, but that do not penalize bad outcomes heavily. The top management of Enron (see Chapter 1) arguably went too far in this direc- tion, inducing their managers to take too much risk (effectively transforming their behavior from risk averse to “risk loving”).24 We expand on this issue later in the book.
ANALYZING MANAGERIAL DECISIONS: Risk Aversion versus Risk Taking
Lauren Arbittier decides to bet $2,000 on
number 35 of the roulette wheel in a Las Vegas
casino. Almost immediately she starts to question
her decision. Lauren normally is a risk avoider
who hardly ever gambles. But she works at Trilogy
Software where the CEO understands that taking
risks and suffering the consequences are critical to
the firm’s success. The CEO wants to develop peo-
ple who take chances. “You don’t win points . . .
for trying.” Lauren is participating in Trilogy’s
three-month training program for all new recruits.
It educates employees about, among other things,
how to evaluate risky projects, not just to immedi-
ately accept or reject the project because it is risky.
The program also suggests to employees that they
will not be rewarded at Trilogy unless they take
risks. Thus, although Lauren does not like taking
risks, working for Trilogy, she has economic in-
centives to do so.
There are at least three ways in which the Tril-
ogy training program might be effective: (1) It
changes employees’ preferences regarding risk
bearing. (2) It more effectively identifies individu-
als with the risk tolerances that Trilogy desires.
(3) It better communicates the consequences to
Trilogy employees of undertaking risky ventures.
Discuss the likely importance of these three mecha-
nisms.
SOURCE: E. Ramstad (1998), “High Rollers, How Trilogy Software Trains Its Raw Recruits to Be Risk Takers,” The Wall Street Journal (September 21), A1.
24Most managers have risk-averse preferences (utility functions). Managerial actions, however, are a function
of both preferences and constraints. Thus risk-averse preferences can be offset or reinforced by the design of
the compensation plan. Compensation plans that limit the upside potential but not the downside induce less
risky choices, whereas plans that limit the downside but not the upside induce more risky choices.
42 Part 1 Basic Concepts
Summary In this chapter we summarize the way economists view behavior. In the economic model, individuals are seen as having unlimited wants but limited resources. They rank alternative uses of limited resources in terms of preference and choose the most preferred alternative. Individuals are clever in figuring out ways of maximizing their satisfaction (utility) in the face of resource constraints. Individuals are not necessar- ily selfish in the sense that they care only about their personal wealth: They also care about charity, family, religion, and society. They are not infallible supercomputers.
The opportunity cost of using a resource is the value of the resource in its best al- ternative use. For example, the cost of having a manager use five hours to work on a project is the value of the manager’s time in working on the next best alternative pro- ject. Economic decision making requires careful consideration of the relevant oppor- tunity costs.
Marginal costs and benefits are the incremental costs and benefits that are associ- ated with a decision. In calculating marginal costs, it is important to incorporate the opportunity costs of the incremental resources. For example, in deciding whether to purchase a new laptop computer, the marginal cost is its price and the marginal ben- efit is the value that the person places on the new computer. It is the marginal costs and benefits that are important in economic decision making. Action should be taken when the marginal benefits are greater than the marginal costs. Sunk costs that are not affected by the decision (e.g., unrecoverable funds previously spent on computers) are not relevant.
A utility function is a mathematical function that relates total utility to the amounts that an individual has of whatever items the individual cares about (goods). Preferences implied by a utility function are pictured graphically by indifference curves. Indifference curves depict all combinations of goods that yield the same level of utility. Individual choice involves maximizing utility given resource constraints. Graphically, the constraint depicts all combinations of goods that are feasible to ac- quire; it defines the feasible consumption opportunities. The optimal choice is where the indifference curve is tangent to the constraint. At this point, the individual is at the highest level of utility possible given the feasible opportunities.
Changes in opportunities result in changes in the optimal choice. An important implication is that managers can affect behavior by affecting constraints and opportunities. Managers, however, have to be careful. Individuals are clever at max- imizing their utility, and establishing disfunctional incentives can have perverse consequences.
We contrast the economic model with other models of human behavior that man- agers often use. We argue that the economic model is often more useful than alter- native models in managerial decision making.
The analysis in this chapter can be extended to the case where the decision maker faces uncertainty about the items of choice. An example of decision making under uncertainty is choosing among risky investment alternatives. One concept on which we will rely later in this book is risk aversion. When confronted with both a risky and a certain alternative having the same expected (or average) payoffs, a risk-averse per- son always will choose the certain outcome. A risk premium must be offered to en- tice the person to choose the risky alternative.
Throughout this chapter, we focus primarily on how managers might use this eco- nomic view to analyze and influence the behavior of employees. As we will see, the economic view is quite powerful and useful in explaining behavior in a variety of different contexts.
Chapter 2 Economists’ View of Behavior 43
G. Becker (1993), “Nobel Lecture: The Economic Way of Looking at Behavior,” Journal of Politi- cal Economy 101, 385–409.
M. Jensen and W. Meckling (1994), “The Nature of Man,” Journal of Applied Corporate Finance 7, 4–19.
2–1. Suppose there are only two goods that Bob cares about—(1) material welfare and (2) leisure time that he “buys” from the outside world at $40 per unit and $20 per hour, re-
spectively. He currently lives and works in Atlanta, has a budget totaling $1,000 per week for
these two goods, and consumes 11 units of material welfare and 28 hours of leisure time.
a. Show Bob’s consumption choice on a graph using the actual budget line and a hypothet- ical indifference curve. (Label the axes and show the x and y intercepts.)
b. How will Bob’s optimal consumption choice change if the government imposes a $10/unit tax on the material welfare good?
c. Suppose Bob has a chance to move (at zero cost) to Saint Louis where material welfare and leisure time cost $50 and $10, respectively. His budget remains the same as before
and the government has decided not to impose a tax on the material good. Would Bob
move to Saint Louis? Why or why not? Explain.
2–2. Amiko is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has an expected
value of $25,000 and a standard deviation of $10,000. This places her on an indifference
curve with the following formula: Expected Value � $15,000 � Standard Deviation a. Is Amiko risk-averse? Explain. b. What is Amiko’s “certainty equivalent” for her current investment? What does this mean? c. What is the risk premium on Amiko’s current investment?
2–3. You have won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next best alternative activity. Tickets to
see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan.
Assume there are no other costs of seeing either performer. Based on this information, what
is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $5025
Solutions to Self-Evaluation Problems 2–1. Individual Choice
a.
b. The $10 tax increases the price of material welfare from $40 to $50. Refer to Figure 2.6 to see the effects of a price increase on optimal consumption (replace food with material
B1
u1
M a te
ri a l w
e lfa
re u
n its
5028
11
25
Leisure time (hours)
Self-Evaluation Problems
Suggested Readings
25Suggested by R. Frank (2005), “The Opportunity Costs of Economics Education,” New York Times (September 1), C2.
44 Part 1 Basic Concepts
welfare on the vertical axis and clothing with leisure time on the horizontal axis). Bob is
likely to reduce his consumption of material welfare due to the price increase. His con-
sumption of leisure time could either go up, down, or stay the same depending on the
exact nature of his adjustment. The change in relative prices (reflected in the flatter bud-
get line) will work in the direction of motivating Bob to substitute units of material wel-
fare for more leisure time. However, Bob’s new budget line will not allow him to stay on
the same indifference curve as before (it rotates inward). His consumption of leisure time
will depend on the exact location of the new tangency point on a lower indifference curve
in the graph. Bob was spending $560 to purchase 28 hours of leisure time. Whether Bob
consumes more or less leisure time after the price increase depends on how much money
he has left over after buying fewer units of material welfare at the new higher price. For
example, if he only reduces his consumption of material welfare from 11 to 10 units, he
will have less money to spend on leisure time than before ($500 versus $560). Alterna-
tively, if he reduces his consumption of material welfare to 8 or fewer units he will have
more money than he had before to spend on leisure time. Which option he chooses de-
pends on his specific utility function.
c. Bob would want to move to Saint Louis. In Saint Louis, his current consumption bundle only costs $830. This leaves $170 to spend on other goods. Since more is better than
less, he can always do better in Saint Louis than he is currently doing in Atlanta.
2–2. Decision Making Under Uncertainty a. Yes, Amiko is risk-averse. She is willing to take on more risk only if it is associated
with a sufficiently higher expected return.
b. Amiko’s certainty equivalent is $15,000. She would be willing to accept a certain return of $15,000 (the vertical intercept of her indifference curve) in lieu of her current risky
investment that has an expected return of $25,000 and a standard deviation of $10,000.
c. The risk premium on Amiko’s current investment is $10,000. This is the difference in the expected return of her risky investment and the risk-free investment (certainty equiv-
alent). The $10,000 risk premium is what it takes in expected return to make her indif-
ferent between the risk and risk-free investments.
2–3. Opportunity cost is a subtle concept that requires careful analysis to implement. Even trained economists can make mistakes if they are not careful to include all relevant costs in
the analysis. Two researchers from Georgia State University (P. Ferraro and L. Taylor)
posed the question to 200 professional economists at an annual meeting.
A careful application of the definition of opportunity costs yields a clear answer—$10.
The next best alternative use of your time, going to the Bob Dylan concert, produces a net
benefit of $10 (the $50 value you place on the Dylan concert minus the $40 to purchase
the ticket). Marginal analysis implies that you should go to the Clapton concert as long as
you obtain at least $10 worth of happiness from the concert. For example, if you value the
Clapton concert at $15, you are $5 better off going to the Clapton concert than the Dylan
concert, which yields only $10 of net value. Interestingly, only 21.6 percent of the profes-
sional economists surveyed chose the correct answer, a smaller percentage than if they had
chosen randomly. Additional surveys revealed that the incorrect answers were driven by
faulty analysis and not by the specific wording of the question. College students who had
taken a course in economics did even worse.
The lesson is that managers, students, and even economists should be careful to include
all of the relevant explicit and implicit opportunity costs in their analyses. Missing a hypo-
thetical question on opportunity costs is inconsequential. Managers can destroy significant
value if they make mistakes in evaluating opportunity costs in their decision making.
2–1. Which costs are pertinent to economic decision making? Which costs are not relevant?
2–2. A noted economist was asked what he did with his “free time.” He responded by saying that “time is not free.” Explain this response.
Review Questions
Chapter 2 Economists’ View of Behavior 45
2–3. The Solace Company has an inventory of steel that it originally purchased for $20,000. It currently has an offer to sell the steel for $30,000. Should Solace’s management agree to sell?
Explain.
2–4. Suppose that you have $900 and want to invest the money for one year. There are three ex- isting options.
a. The city of Rochester is selling bonds at $90 per unit. The bonds pay $100 at the end of one year when they mature (no other cash flows).
b. Put the money under your mattress. c. The one-year interest rate of saving in the Chase Bank is 7 percent.
Which one will you choose? What is the opportunity cost of your choice? Explain.
2–5. Suppose Juan’s utility function is given by U � FC, where F and C are the two goods avail- able for purchase: food and clothing.
a. Graph Juan’s indifference curves for the following levels of utility: 100, 200, and 300. b. Are these curves convex or concave to the origin? What does this shape imply about
Juan’s willingness to trade food for clothing?
c. Suppose Juan’s budget is $100 and the prices of F and C are both $5. Graph the budget constraint.
d. How many units of food and clothing will Juan purchase at these prices and income? Show graphically. What is his corresponding level of utility?
e. The Johnson Company is the sole producer of clothing. What can the company do to in- duce Juan to purchase more clothing? Show graphically. (The graph does not have to be
exact.)
2–6. Suppose that Bob’s indifference curves are straight lines (as opposed to being convex to the origin). What does this imply about Bob’s willingness to trade one good for the other? Give
examples of goods where this type of behavior might be expected?
2–7. Suppose that Bob’s indifference curves are perfectly L-shaped with the right angle occurring when Bob has equal amounts of both goods. What does this imply about Bob’s willingness to
trade one good for the other? Give examples of goods where this type of behavior might be
expected?
2–8. a. Briefly describe the five models of behavior presented in this chapter. b. What are the implications of these models for managers attempting to influence their
employees’ behavior?
2–9. Employees in a plant in Minnesota are observed to be industrious and very productive. Employees in a similar plant in southern California are observed to be lazy and unproduc-
tive. Discuss how alternative views of human behavior and motivation might suggest differ-
ent explanations for this observed behavior.
2–10. Employees at a department store are observed engaging in the following behavior: (a) they hide items that are on sale from the customers, and (b) they exert little effort in designing
merchandise displays. They are also uncooperative with one another. What do you think
might be causing this behavior, and what might you do to improve the situation?
2–11. One of the main tenets of economic analysis is that people act in their own narrow self- interest. Why then do people leave tips in restaurants? If a study were to compare the size
of tips earned by servers in restaurants on interstate highways with those in restaurants near
residential neighborhoods, what would you expect to find? Why?
2–12. Several school districts have attempted to increase teacher productivity by paying teachers based on the scores their students achieve on standardized tests (administered by outside
testing agencies). The goal is to produce higher-quality classroom instruction. Do you think
that this type of compensation scheme will produce the desired outcome? Explain.
2–13. A company recently raised the pay of employees by 20 percent. Employee productivity remained the same. The CEO of the company was quoted as saying, “It just goes to show
that money does not motivate people.” Provide a critical evaluation of this statement.
46 Part 1 Basic Concepts
2–14. One physician who worked for a large health maintenance organization was quoted as saying:
One day I was listening to a patient’s heart and realized there was an abnormal rhythm. My first thought was that I hoped that I did not have to refer the patient to a specialist.
Indeed, HMO physicians have been criticized for not making referrals when they are war-
ranted. How do you think the physician was compensated by the HMO? Explain.
2–15. Insurance companies have to generate enough revenue to cover their costs and make a normal profit—otherwise, they will go out of business. This implies that the premiums charged for
insurance policies must be greater than the expected payouts to the policyholders. Why would
a person ever buy insurance, knowing that the price is greater than the expected payout?
2–16. Critically evaluate the following statement: “Risk-averse people never take gambles.”
2–17. Suppose that an investment can yield three possible cash flows: $5,000; $1,000; or $0. The probability of each outcome is 1�3. a. What is the expected value and standard deviation of the investment? b. How much would a risk-neutral person be willing to pay for the investment? c. How much would a risk-averse person be willing to pay for the investment?
2–18. In order to spur consumer spending in 1998, the Japanese government considered an $85 bil- lion voucher system whereby every Japanese consumer would receive a shopping voucher
that could be used to purchase Japanese products. For simplicity, assume the following: Each
consumer has wealth of 1 million yen, consumers must allocate this wealth between con-
sumption now (c1) and consumption later (c2), the interest rate is zero, the voucher is worth 100,000 yen, and it can be spent only in the current period. If it is not spent, it is lost.
a. Plot a budget line for a representative consumer both before and after the voucher pro- gram (c1 and c2 are on the axes).
b. Do you expect that current consumption of a typical consumer will increase by the full 100,000 yen of the voucher? Explain.
c. How does the impact of this 100,000-yen voucher differ from simply giving the individ- ual 100,000 yen?
2–19. People give to charity. a. Is this action consistent with the “economic view of behavior”? Explain. b. Suppose there is a big drop in charitable giving. At the same time there has been no de-
cline in per capita income or total employment. Using the economic model, what poten-
tial factors might have led to this decline in giving?
c. How might the decline in giving be explained by the product-of-the environment model?
2–20. The Japanese are very good at returning lost property to local police stations. If you lose a wallet filled with cash in Japan it is likely to be turned into the police. This is true even
though the person finding it could keep it without anyone else knowing. This behavior is not
what you would find in New York City.
a. Does this observation about Japan imply that the economic model does not explain be- havior in Japan? Explain.
b. Police stations in Japan are filled with lost umbrellas. It used to be that the typical Japanese would make a trip to the local police station to search for a lost umbrella. Now
they don’t. Explain this behavior using the Economic Model.
c. Do you think that the typical Japanese is more likely to come to a police station to find a lost cell phone or a lost umbrella? Explain using the Economic Model.
2–21. Some states in the United States allow citizens to carry handguns. Citizens can protect them- selves in the case of robberies by using these guns. Other states do not allow citizens to carry
handguns. Criminals, however, tend to have handguns in all states. Use economic analysis to predict the effects of handgun laws on the behavior of the typical criminal. In particular:
(1) Do you think criminals will commit more or fewer robberies in the states with the laws?
(2) How do you think the laws will affect the types of robberies criminals commit? Be sure to explain your economic reasoning.
2–22. Discuss the following statement: “Sunk costs matter. People who pay $20,000 to join a golf club play golf more frequently than people who play on public golf courses.”
Chapter 2 Economists’ View of Behavior 47
2–23. Jenny is an investor in the stock market. She cares about both the expected value and stan- dard deviation of her investment. Currently she is invested in a security that has an expected
value of $15,000 and a standard deviation of $5,000. This places her on an indifference
curve with the following formula: Expected Value � $10,000 � Standard Deviation. a. Is Jenny risk averse? Explain. b. What is Jenny’s “certainty equivalent” for her current investment? What does this mean? c. What is the risk premium on her current investment?
2–24. Accounting problems at Enron ultimately led to the collapse of the large accounting firm Arthur Andersen. When the Enron scandal first became public, Andersen’s top management
blamed one “rogue partner” in the Houston office who they claimed was less honest than
other partners at the firm. They fired the partner and asked that people not hold the remain-
ing partners accountable for “one bad apple.” What model of behavior was Andersen’s man-
agement using when it analyzed the source of the problem? According to the economic
view of behavior, what was the more likely cause of the problem?
2–25. According to a recent article in The Atlanta Journal-Constitution (January 29, 2004), “ma- terialism, not necessity, gave birth to dual-income families.” In supporting the argument, the
author cites the following figures from the Department of Commerce: In 1970 the average
wage per job was $6,900, which in 2001 dollars (adjusting for inflation) amounts to
$31,500. In 2001, the average wage per job was $35,500. The main thesis of the article is
that dual-income families are a result of a shift in consumer preferences toward consump-
tion as opposed to leisure time/time spent with the family.
a. Assume the average person worked 250 days during a year both in 1970 and 2001, and that, as reported in the article, only one person worked in the average family in 1970,
while both parents did in 2001. Provide a graphical analysis of the typical family’s
choice between family income and combined parent leisure time that supports the au-
thor’s argument, relying on the tools presented in class. Be careful in labeling your
graph(s), and provide a clear and concise explanation for your graph(s). Note that there
are 365 days in a year so that the total parent leisure time that is possible is 730 days
(assuming neither spouse works). Assume it is possible for each family member to work
anywhere from 0 to 365 days a year (at the going salary rate) if they choose to do so.
b. Assume that in 1971 the average single person worked 220 days per year, while the same person worked 260 days per year in 2001. Moreover, suppose the average daily
wage in 2001 dollars was $125 in 1970 and $140 in 2001. Show graphically how the au-
thor’s argument would not necessarily apply to the average single person (i.e., assume
preferences are unchanged). Explain clearly and concisely why the average worker may
be choosing to work more in 2001 and carefully label your graph.
2-26. Russell and Joe have hired Maria to help cook in their restaurant. Maria had previously owned her own breakfast business. Her speed in cooking was well-known. Russell and Joe
have been surprised that her productivity has fallen significantly since she became their paid
employee. Use the economic view of behavior and marginal analysis to provide a potential
explanation for Maria’s reduced productivity.
2-27. Michael is a fan of the Rhinos—the local professional soccer team. At the beginning of the season, he purchased nonrefundable season tickets to their 10 home games for a total of
$100. Michael places equal value on each of the home games. His value for any given game
is independent of how many other games he attended during the year. Michael would be
willing to stay at home, which he derives no benefit from, and miss an individual game, if
he could sell the ticket for one game for $20 or more.
Michael has attended three out of the last five home games. The sixth home game of the
season is tomorrow night. Michael’s friend Fred has offered to sell him an extra ticket to a
sold-out concert for $50 that happens to be on the same night as the game. Normally,
Michael would be willing to pay $70 to attend the concert. There is no way that Michael
can attend both the Rhinos’ game and the concert. Looking online, Michael finds that he
can sell his ticket for tomorrow night’s Rhinos’ game for $5.
a. What type/types of cost is the $100 that Michael paid for the season tickets? Explain why. b. Which event will Michael decide to attend? Explain why.
48 Part 1 Basic Concepts
c. How much would Fred have to charge Michael for the concert ticket in order to make Michael not care which event he attended? Explain why.
2-28. An entrepreneur quits his job as a banker and invests $100,000 of his savings in a new busi- ness venture that he will manage. Discuss the two most obvious opportunity costs that he
will incur from this decision.
2-29. In one hour, John can assemble either 20 telephones or 10 answering machines. It takes Sally two hours to assemble either 20 telephones or 10 answering machines. Does either
person have an absolute advantage in assembling either product? What about a competitive
advantage? Explain (make sure you define absolute and competitive advantage and provide
the opportunity costs for each person). Draw the combined production possibilities curve
for the two people assuming that they work eight hours. Put answering machines on the
horizontal axis.
2-30. You are trying to decide whether to fly or drive from Rochester to Boston during your sum- mer visit. The trip is approximately 400 miles. You can purchase a round-trip nonstop flight
for $230. The duration of each flight is 3.5 hours (seven hours in total). If you drive, it will
take you approximately seven hours each way (14 hours in total). Your car gets 32 miles to
the gallon and you expect gas will cost $3/gal. Tolls are $15 each way. You value your time
at $15 per hour.
a. Calculate the total cost of driving to Boston and back. b. Under these conditions, will you drive or fly? c. What if you value your time at $20, rather than $15, per hour? d. You are offered a deal for $180 total airfare if you take a flight with a one hour layover
in NYC (total flying time does not change). Do you take the deal? Will this change
your flying versus driving decision? (Use the $15 per hour value of time in the
calculation.)
e. What are some other costs you may want to consider in this analysis? f. If you were expecting a snow storm, how might this change your analysis? What are
some other costs you may want to take into consideration?
2-31. The school is having a happy hour on Friday. If you go, you will get two free drink tickets and snacks, for which you would normally pay $15. However, you will have to pay $10 for
the cab fare home. You also have a free student ticket to the local profession team’s soccer
game. There is no resale value, as free tickets are still available.
a. What is the opportunity cost of going to the soccer game? b. If you would not normally pay to go to the soccer game, which will you choose?
2-32. Bill and Chris produce balls and bats. In one hour, Bill can produce two bats or four balls, while Chris can produce one bat or three balls. They each work 10 hours a day.
a. Which of the following, if any, is true? Explain why. 1. Chris has an absolute advantage producing balls and a comparative advantage
producing balls.
2. Chris has an absolute advantage producing balls and Bill has a comparative advantage producing balls.
3. Bill has an absolute advantage producing balls and a comparative advantage producing balls.
4. Bill has an absolute advantage producing balls and Chris has a comparative advantage producing balls.
b. If Chris and Bill each split their time evenly between producing balls and producing bats, what is the total number of bats and balls that will be produced in one day?
c. Can the combined production of balls be increased while holding the number of bats produced constant? How?
d. Graph the combined production possibilities frontier for Bill and Chris. Place Bats on the vertical axis and Balls on the horizontal axis. [The graph would show the maximum com-
bined amount of bats that could be produced by Bill and Chris for each feasible combined
amount of balls that could be produced.]
Chapter 2 Economists’ View of Behavior 49
Appendix A: The main text of this chapter provided a simple graphical analysis of individual choice. Consumer It introduced utility functions, indifference curves, and budget lines. It depicted the op-
Choice timal choice as the tangency between an indifference curve and the budget line where the willingness and ability to trade are equal. This simple analysis explained how the optimal choice changes with changes in relative prices or income. This economic framework has important implications since managers often want to influence and/or predict the behavior of individuals, such as customers and employees.
This appendix extends the economic framework of individual choice (commonly called consumer choice). Its intent is to provide a deeper and richer understanding of this important model of behavior. This appendix also discusses how this model re- lates to an important topic that is covered in more detail later in this book—demand functions.
Marginal Utility A utility function expresses the relation between a person’s total utility and the level of goods consumed. Utility functions can take many forms. For illustration, suppose that Tom Morrell values only food and clothing and that his utility function is
U � FC (2.9)
where F is the units of food and C is the units of clothing that Tom consumes within the period. Notice, this simple utility function is multiplicative in both food and clothing. If Tom has no clothing, then no matter how much food he has, he has utility of zero. Likewise, if he has no food, then no matter has much clothing he has, his utility again is zero. If Tom’s consumption bundle consists of 20 units of both food and clothing his utility is 400, while his utility is only 100 if he has 10 units of both goods. Tom prefers the first bundle, but he is not necessarily four times happier when he has 20 units, rather than 10 units, of each good. The utility function provides an ordinal ranking of consumption bundles—not a cardinal rank- ing where “absolute” comparisons can be made.
Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. Marginal utility is an important concept in economic analysis since optimizing individuals focus on the mar- ginal (incremental) benefits and costs in making consumption choices. Figure 2.10 graphs Tom’s utility as a function of food, while holding clothing constant at 10 units. The equation for this graph is
U � 10F (2.10)
The marginal utility of food in this example is 10—for each additional unit of food that Tom consumes he receives 10 additional units of utility. More generally for any given quantity of clothing, C, the marginal utility of food is C (given Tom’s utility function). Similar logic implies that the marginal utility of clothing is F.26 We denote the marginal utilities for food and clothing by MUF and MUC , respectively.
26Note for the mathematically inclined: The marginal utility of any good X is equal to the partial derivative of the utility function with respect to X. In this example, the partial derivative with respect to F is C, and with respect to C is F. In this example, the marginal utility of each good is constant. More realistically, the marginal utility of a good will eventually decline as the consumer continues to receive more of the good. We
employ this utility function only to simplify the presentation.
50 Part 1 Basic Concepts
Slope of an Indifference Curve Now that we have defined marginal utility, we can derive the slope of an indifference curve. Consider Tom’s indifference curve for U � 100. The equation for this indif- ference curve, which is pictured in Figure 2.11, is F � 100�C.27 Because all points on the indifference curve generate 100 units of utility, the total gain in utility
0
U til
ity
50
100
150
200
250
300
350
400
1 3 5 7 9 11
Slope = 100/10 = 10
13 15 17 19 21 23 25 27 29 31 33 35 Food (F )
1
10
Figure 2.10 Tom’s Utility as a Function of Food with Clothing Held Constant at 10 Units (U � 10F )
This figure displays Tom’s utility as a function of food with clothing held constant at 10 units. Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. The marginal utility of F in this example is 10 (the slope of the line)—for each additional unit of F that Tom consumes he receives 10 additional units of utility.
27The decision to place food on the y-axis is arbitrary. If we had placed clothing on the y-axis the equation for the indifference curve would be C � 100�F.
5 10 20 Quantity of clothing
5
10
20
Q u
a n
ti ty
o f
fo o
d
Indifference curve for 100 units of utility
A (5, 20): MRS = 4
B (10, 10): MRS = 1
C (20, 5): MRS = .25
Figure 2.11 Slope of One of Tom’s Indifference Curves: �(MUC/MUF)
This figure displays an indifference curve for 100 units of utility from Tom’s utility function: U � FC. The equation for the indifference curve is F � 100�C. The slope of an indifference curve at any point is �(MUC�MUF). The slope at a point is defined as the slope of the tangency line at that point. The tangency lines at points A and C are two examples. In this example, the slope at any point is �(F�C). The absolute value of the slope, which is called the Marginal Rate of Substitution (MRS), declines continuously along the curve. This property implies that Tom becomes less willing to trade F for C as C increases relative to F.
Chapter 2 Economists’ View of Behavior 51
associated with an increase in C must be balanced by an offsetting decline in utility from reduced consumption of F (as Tom moves along the curve):
MUC (�C ) � MUF (�F ) � 0 (2.11)
where �F and �C represent the changes in food and clothing. The first term in Equa- tion (2.11) represents the change in utility from changing the amount of clothing, while the second term represents the change in utility from changing the amount of food. These terms are equal in magnitude and of opposite sign along an indifference curve, and so total utility remains unchanged.
The slope of the indifference curve for a small change in C is given by (�F��C ). Rearranging Equation (2.11):
(�F��C ) � �(MUC�MUF) (2.12) Slope of the indifference curve � �(MUC�MUF)
In the example where U � FC, the slope of the indifference curve is �(F�C ) since MUC � F and MUF � C. For example, at the point where F � 5 and C � 20 the slope is �.25. The intuition for this result is as follows: If a marginal unit of clothing yields five units of utility, while a marginal unit of food yields 20 units of utility, food can be traded for clothing at a rate of .25 units for one unit, and utility will remain the same (for small changes in the two goods).
The absolute value of the slope of an indifference curve is called the Marginal Rate of Substitution (MRS). The MRS reflects the individual’s willingness to trade at a point on an indifference curve (in this example, trading food for clothing). Consider Tom’s willingness to trade when he has a consumption bundle of 10 units of both goods. The slope at this point is �(10�10) � �1. The MRS, which is equal to one, implies that Tom is willing to give up a small quantity of food to receive an equal number of units of clothing. (If Tom were to increase his con- sumption of C by 1 unit he would have to reduce his consumption of F by ap- proximately 1 unit to keep his utility the same.) The MRS declines along the con- vex curve indicating that Tom becomes less willing to trade food for clothing as the amount of clothing increases relative to food.28
Individual Choice Recall that the equation for the budget line is
F � (I�PF) � (PC�PF)C (2.13)
The absolute value of the slope, (PC�PF), reflects the consumer’s ability to trade in the market place. For example, when the price of clothing is $2/unit and the price of food is $1/unit, two units of food must be given up to consume one additional unit of clothing (PC�PF � 2). The intercept (I�PF) indicates how many units of food could be purchased if the entire budget is spent on food.
At the optimal consumption bundle the budget line is tangent to an indifference curve (which is the highest attainable indifference curve given the budget constraint).
28The slope of a curve is defined at a point on a curve and the slope changes along the curve. The slope of �1
at the point [10,10] reflects Tom’s willingness to trade for very small changes in C. For a full unit change in C, the decline in F is only approximately (as we reduce the size of the exchange—.1 unit of food or .01 unit of food—the change in utility approaches zero) equal to one. A one unit increase in C and a one unit decrease in F produce a consumption bundle with 99 units of utility. This value is approximately equal to the starting point of 100.
52 Part 1 Basic Concepts
This condition implies that the MRS is equal to the ratio of the prices at the optimum. Since the MRS is equal to the ratio of the marginal utilities for the two goods:
MUC�MUF � PC�PF (2.14)
The left side of Equation (2.14) represents the willingness to trade, while the right side reflects the ability to trade. At the point where the consumer is maximizing his utility (the optimum), the two are equal.
We can rearrange Equation (2.14) as follows:
MUC�PC � MUF�PF (2.15)
Equation (2.15) is an important and familiar result in consumer theory. It says that the consumer’s utility is maximized when the budget is allocated among goods so that the marginal utility per dollar of expenditure is the same for each good. At any combination where this condition does not hold, the consumer can be made better off by making feasible changes in the consumption bundle. For example, suppose Tom has an initial bundle where the marginal utility per dollar for clothing is 10 and for food is 20. Since he is getting more utility per dollar from food, he should spend less money on clothing and more on food. As he trades clothing for food, his marginal utility of clothing increases while his marginal utility of food decreases. Tom will eventually reach the optimal consumption bundle where the marginal utility-to-price ratios are equal. Equation (2.15) reflects a condition known as the equal marginal principle—the marginal utility per dollar is the same for all goods at the optimum.29
This principle reappears in various forms in the economic analysis of both consumer and producer behavior.
Solving for the Optimal Consumption Bundle Suppose that Tom has a budget of $100 and the prices of food and clothing are $1 and $2, respectively. How much of each good will he buy? This problem is straightforward since it involves two unknown variables (F and C ) and two independent equations. One equation is the optimality condition Equation (2.14); the second is the budget line Equation (2.13).
At Tom’s optimal choice, the MRS must equal the price ratio (i.e., MUC�MUF � PC�PF). Substituting the values for Tom’s marginal utilities yields
F�C � 2 (2.16) C � F�2
Tom must also satisfy his budget constraint:
F � 100 � 2C (2.17)
We can solve for the amount of food that Tom will purchase by substituting Equation (2.16) into Equation (2.17):
F � 100 � 2 (F�2) F* � 50
C* � 25 is found by substituting F* � 50 into Equation (2.16). At the optimal consumption bundle, Tom obtains 1,250 units of utility (25 � 50).
He can increase his consumption of clothing by purchasing 26 units of clothing and
29This condition is also referred to as the “equimarginal principle.”
Chapter 2 Economists’ View of Behavior 53
48 units of food (26 � $2 � 48 � $1 � $100). However, this bundle would yield only 1,248 units of utility (26 � 48). Alternatively, he could decrease his consump- tion of clothing by one unit and increase his consumption of food by two units (C � 24; F � 52). This bundle also would produce only 1,248 units of utility. Indeed any feasible alternative bundle would yield less than 1,250 units of utility.
The equal marginal principle holds at Tom’s optimal consumption bundle—the marginal utility per dollar of expenditure (MUi�Pi) is 25 for both goods. This condition implies that Tom has no incentive to shift expenditures from one good to the other since both goods yield the same marginal utility per dollar of spending.
The marginal utility of income is defined as the additional utility that the con- sumer receives from one additional dollar of income. It can be shown that at the op- timum, the marginal utility-to-price ratio for all goods is equal to the marginal utility of income. For example, if Tom’s income increases by $1, he could increase his util- ity by 25 units by purchasing additional quantities of either good.
Demand Functions A demand function expresses the mathematical relation between the quantity de- manded for a product (how many units consumers will purchase) and the factors that determine consumer choice (such as prices and income). In a more general setting than our simple example, the demand for clothing is likely to be affected by the price of clothing, consumer income, the prices of other products, and other variables (such as advertising expenditures). Managers care about consumer choice since a good under- standing of the demands for their products is important for making productive invest- ment, pricing, advertising, and other decisions. In subsequent chapters, we focus on ag- gregate demand for a product (total demand across all consumers in the market) without directly tying the analysis back to individual consumer behavior as analyzed in this chapter. Nevertheless, it is useful to recognize that aggregate demand for a given product can conceptually be derived from the framework presented in this appendix.
The derivation of Tom’s demand function for either food or clothing is particu- larly easy (given his utility function). Tom’s optimal consumption bundle is where his MRS equals the price ratio. In Tom’s case, this condition is
F�C � PC�PF (2.18) Tom’s total expenditures on either food or clothing is equal to the quantity purchased of the good times its price. By cross-multiplying Equation (2.18) we see that Tom’s expenditures on food and clothing are always equal:
(F � PF) � (C � PC) (2.19)
Equation (2.19) implies that Tom will always spend half his income on each good (this result is driven by his particular utility function). It follows that Tom’s total ex- penditures on clothing are (C � PC) � I�2. Solving for C produces Tom’s demand function for clothing:
C � I�(2PC) (2.20) This demand function implies that Tom will purchase more clothing as his income rises and less clothing as his income falls. His clothing purchases vary inversely with the price of clothing.
In our example, Tom had an income of $100 and PC � $2/unit. Consistent with Equation (2.20), we found that he consumed 25 units of clothing. The demand func- tion implies that if Tom’s income were to increase to $200 (holding price constant)
54 Part 1 Basic Concepts
he would purchase 50 units of clothing. In contrast, his clothing purchases would fall to 12.5 units if PC increased to $4 (holding income constant at $100). Tom is only one consumer who purchases clothing. The total (aggregate) quantity demanded for clothing at a given price is equal to the sum of the purchases made by all consumers in the market.
Since Tom always spends half his income on clothing, the amount of clothing that he purchases is not affected by the price of food. This is a special case, which does not hold for many other utility functions. Consider Anne George whose utility func- tion is U � C .5 � F.5. Anne’s demand for clothing is C � I�[(P 2C�PF) � PC ].30 This function indicates that Anne’s clothing purchases increase with income and the price of food, but decrease with the price of clothing. For example, at the initial prices and income (PF � $1, PC � $2, and I � $100) Anne purchases 16.67 units of clothing. If the price of food were to increase from $1 to $2, her demand for clothing increases to 25 units. When the prices for food and clothing are equal she spends half her in- come on each good. As relative prices change, Anne spends a higher percentage of her income on the relatively less-expensive good.
Income and Substitution Effects Equation (2.20) indicates that Tom’s demand for clothing decreases with the price of clothing. Figure 2.12 displays the example where the price of clothing increases from $2 to $4 (holding income constant at $100 and the price of food at $1). Remember, Tom’s utility function is U � CF. The price increase causes the budget line to rotate inward. The new budget line, B 2 is steeper than the original line, B1 (slopes of �4 and �2, respectively).
The inward shift of the budget line implies that Tom has less purchasing power than he had prior to the price increase. The area between the two budget lines con- tains consumption bundles that he could have purchased when PC � $2 that he can no longer afford. The reduced consumption possibilities imply that Tom has effec- tively less purchasing power than he had prior to the price increase. Thus, an increase in the price of clothing has two effects. One is to increase the price of clothing rela- tive to the price of food (i.e., PC�PF increases); the other is to reduce Tom’s effective income (purchasing power). As we will see, both effects influence Tom’s response to the price increase.
Tom purchased 25 units of clothing and 50 units of food when PC � $2, PF � 1, and I � $100. This choice, which is at the point of tangency between the original indifference curve, I1, and budget line, B1, is labeled as t1 in Figure 2.12. His optimal consumption bundle following the price increase, consisting of 12.5 units of clothing and 50 units of food, is pictured by the point of tangency, t2, between the indifference curve, I2, and the new budget line, B2. The decline in the quantity demanded for clothing from 25 units to 12.5 units represents the total effect of the price change (a decrease of 12.5 units). The total effect can be decomposed into a substitution effect and an income effect.
The substitution effect is the change in the quantity demanded of a good when its price changes, holding the prices of other goods and utility constant. To hold utility constant, Tom must be compensated for the price increase by receiving enough addi- tional income to maintain his previous level of utility of 1,250 units (U � FC � 25 � 50 � 1,250). Without this increase in income, he could not afford any of the bundles
30For practice, derive the demand function from Anne’s utility function (for this utility function: MUC � .5C (�.5) and MUF � .5F
(�.5)).
Chapter 2 Economists’ View of Behavior 55
on the original indifference curve at the new prices. To focus on the effect of changes in relative prices (versus changes in effective income), we examine what Tom would do if he actually received this hypothetical income increase. This hypothetical situa- tion is depicted by an imaginary budget line, B in Figure 2.12—which is parallel to the new budget line, B2, and tangent to the original indifference curve, I1, at t . The resulting combination of 70.6 units of food and 17.7 units of clothing is the least expensive bundle that Tom can purchase at the new prices that yields 1,250 units of utility.31 Since the cost is $141.40, Tom’s income would have to increase by $41.40 to afford this combination. Thus, if he were to receive enough additional income to compensate for the price increase, he would respond by purchasing 7.3 units less of clothing and 20.6 units more of food than when the price of clothing was only $2. This substitution between clothing and food occurs because clothing is relatively more expensive. Figure 2.12 depicts the 7.3 unit decline in Tom’s clothing purchases with an arrow labeled “substitution effect.” The convexity of the indifference curves implies that the substitution effect is positive.
70.6
100
F o o d
50
12.5 25 50 Clothing
17.7
Substitution effect: 25 – 17.7 = 7.3
Income effect: 17.7 – 12.5 = 5.2
Total effect = (7.3 + 5.2) = 12.5
I1 (utility = 1,250 units) I2 (utility = 625 units)
t1
B1
B2
t
t2
B
Figure 2.12 Income and Substitution Effects
This figure illustrates income and substitution effects. Tom’s original budget line and indifference curve are denoted by B1 and l1; here he chooses 25 units of clothing and 50 units of food as denoted by t1. An increase in the price of clothing from $2 to $4 causes the budget line to rotate inward as pictured by B2. At the new optimum, t2, Tom purchases 12.5 units of clothing and 50 units of food. The 12.5 unit decline in the demand for clothing is the total effect of the price change, which is the sum of the substitution and income effects. The substitution effect is 7.3 units. It is pictured by Tom’s optimal choice, t , which assumes that Tom has received additional income to keep him on the original indifference curve. The income effect of 5.2 units is the additional decline in demand due to the fact that Tom does not actually receive the hypothetical increase in income. The hypothetical increase is used to isolate the “pure price effect” from the effect of reduced purchasing power due to the price increase.
31This consumption bundle is found by solving two equations simultaneously. One equation is for the
indifference curve containing bundles that yield 1,250 units of utility (F � 1,250�C); the second equation is that the slope of the indifference curve and the new budget line are equal at the point of tangency (F�C � 4).
56 Part 1 Basic Concepts
The hypothetical $41.40 increase in income is used to isolate the “pure effect” of the change in relative prices. Since Tom does not actually receive this extra income, he will not be able to purchase 70.6 units of food and 17.7 units of clothing (his ac- tual income is still $100). The decline in purchasing power from the price increase has an additional effect on Tom’s demands for clothing and food. The income effect is the change in the quantity demanded of a good because of a change in purchasing power, holding prices constant. The parallel shift in the budget constraint from B to B2 in Figure 2.12 captures Tom’s effective decrease in income. As Tom’s budget de- creases from the hypothetical level of $141.40 to the actual level of $100, he con- sumes 5.2 fewer units of clothing (17.7 � 12.5 � 5.2). The 5.2 unit reduction in quantity demanded is depicted in Figure 2.12 with an arrow labeled “income effect.”
The total effect is that Tom’s quantity demanded for clothing drops by 12.5 units (25 � 12.5 � 12.5) due to the price increase. The total effect, which is the sum of the substitution and income effects, is pictured by an arrow labeled “total effect.” The final result is that Tom purchases 12.5 units of clothing and 50 units of food and ob- tains 625 units of utility (50 � 12.5):
Total Effect � Substitution Effect � Income Effect
12.5 � 7.3 � 5.2
The substitution effect is always positive—changes in relative prices motivate sub- stitutions toward the relatively less-expensive good. The income effect for a normal good is also positive. As income decreases (increases) total consumption must decrease (increase); thus, on average the demand for goods must move in the same di- rection as the income change. Nonetheless, for some goods the income effect is nega- tive. For example, in contrast to a normal good the demand for canned meat products is likely to vary inversely with income (wealthy people are likely to shun canned meat and purchase fresh meat, such as steak). We call goods with demands that vary in- versely with income inferior goods. A positive income effect reinforces the substitu- tion effect and increases the magnitude of the response, while a negative income effect mitigates the substitution effect and reduces the magnitude of the response. In Tom’s case the 7.3 unit substitution effect is reinforced by the 5.2 unit income effect. For most goods, the income effect is small relative to the substitution effect, and thus the total effect usually is in the same direction as the substitution effect.
The income effect in Tom’s case is relatively large (42 percent of the total effect). This is due to the assumption that Tom can only purchase two goods. Since Tom spends half his budget on clothing, he experiences a large drop in purchasing power when the price of clothing doubles. In contrast to this simple example, most con- sumers purchase many goods and spend a relatively small percentage of their bud- gets on any one good (e.g., salt, toothpaste, apples, and so on). Thus, a change in the prices of the typical good does not have an important effect on the purchasing power of the consumer. This observation implies that for many products the substitution ef- fect is much more important than the income effect. For example, suppose that your nearby grocery store raises the price of cucumbers by $1/pound. Conceptually, your income (purchasing power) is lower than it was before since you can no longer pur- chase as many potential consumption bundles. This small decline in effective in- come, however, is not likely to be the driving force behind your response to the price change. The relative increase in the price of cucumbers might motivate you to use more tomatoes and fewer cucumbers in your next salad. However, this decision is driven by the change in relative prices of cucumbers and tomatoes—not by the small change in your purchasing power.
Chapter 2 Economists’ View of Behavior 57
Some goods, such as housing or transportation, constitute a relatively large propor- tion of the typical consumer’s budget. For these goods, income effects can be more important. Since these goods are the exception rather than the rule, we can safely ignore income effects in many applications. Correspondingly, we tend to concentrate on sub- stitution effects in analyzing the effects of changes in relative prices. The reader, how- ever, should be aware that other applications exist where income effects are important.
One prominent case where income effects can be important is the supply of labor. Figure 2.13 depicts Ralph Kramden who is choosing between work and leisure time. Ralph is a bus driver whose employer allows him to choose the number of hours he works each week. Ralph has a total of 100 hours per week that he divides between work and leisure activities (the remaining hours are used for sleeping, etc.). At a wage rate of $10 per hour, Ralph chooses to work 60 hours per week and has a total income of $600; the other 40 hours are used for leisure activities. The budget line ro- tates outward when the wage rate is increased to $20/hr. The new budget line is flat- ter than the original line (slope is 1�20 versus 1�10). The reduced slope captures the increase in the opportunity cost of leisure—leisure now costs Ralph $20/hr. The sub- stitution effect works in the direction of motivating Ralph to reduce his leisure time and to work more hours. The substitution effect in this example, however, is out- weighed by the income effect. At the higher wage rate, Ralph chooses to work only 40 hours per week; his total income is $800, which is $200 more than he made work- ing 60 hours at $10/hr. At an income level of $800, Ralph values an additional hour of leisure time at more than the $20 he could make from using the hour for work. At the lower level of income ($600) he placed a smaller value on an extra hour of leisure time (he had to work more hours to provide basic support for his family).
Magnitude of the Substitution Effect Economists typically assume that indifference curves are convex to the origin. Con- vexity is consistent with the behavioral observation that a person’s willingness to
$600
40
60
100
L e is
u re
t im
e (
h r)
Total income $1,000 $2,000
Budget line for wage = $20/hr.
Budget line for wage = $10/hr.
Figure 2.13 Income Effects in the Supply of Labor
This figure displays Ralph Kramden’s choice between work and leisure. Ralph has a total of 100 hours per week that he divides between work and leisure activities (the remaining hours are used for sleeping, etc.). At a wage rate of $10/hr., Ralph works 60 hours/week and has a total income of $600. At a wage rate of $20/hr., he chooses to work fewer hours (40) and to consume more leisure time (60 hours). While the increase in the wage rate increases the opportunity cost of leisure time, the income effect is larger than the substitution effect. At the higher income level ($800), Ralph places greater value on leisure time and works 20 fewer hours than when the wage rate was $10/hr.
58 Part 1 Basic Concepts
trade one good for the other generally declines as the relative amount of the second good increases (i.e., the MRS declines as the good on the horizontal axis increases). While Tom is willing to trade a large amount of food for a unit of clothing when he has lots of food and little clothing, his willingness to trade food for clothing declines as he reduces his food stock relative to his supply of clothing.
The substitution effect is always positive with convex indifference curves. An in- crease in the relative price of one good motivates substitution away from that good to- ward other goods (holding utility constant). The magnitude of the substitution effect, however, varies depending on the convexity (curvature) of the indifference curve.
Figure 2.14 compares the typical indifference curve with the two extremes. The first extreme is the case of perfect complements where the indifference curve is shaped as a right angle. In this case, the two goods are used in fixed proportions. An individual receives no additional utility from receiving more units of just one of the goods. For utility to increase, the quantity of both goods must increase. An example is shoes. The typical individual requires both a left and right shoe. Utility is not in- creased if the individual receives a right shoe unless it is matched with a left shoe.
The other extreme is perfect substitutes, where the indifference curve is a straight line. In this case, the MRS does not change as the person receives more of one good relative to the other. For example, a person’s willingness to trade $10 bills for $20 bills remains at 2 for 1 regardless of the relative supply of the two goods.
While most goods are neither perfect complements nor perfect substitutes, the con- vexity of indifference curves varies among products. Some indifference curves have sig- nificant curvature (tend to be closer to right angles), while others are relatively straight. The substitution effect is smaller when the indifference curve is more convex (closer to perfect complements). For example, a small increase in the price of left shoes will not motivate consumers to purchase fewer left shoes and more right shoes. In contrast, a small price change can motivate large shifts from one good to another when they are
G o o d Y
Good X
G o o d Y
Good X
G o o d Y
Good X
Normal Case Perfect SubstitutesPerfect Complements
Figure 2.14 Convexity of Indifference Curves
This figure compares the typical indifference curve with the two extremes. The first extreme is the case of perfect complements where the indifference curve is shaped as a right angle. In this case, the two goods are used in fixed proportions. An individual receives no additional utility from receiving more units of just one of the goods. The other extreme case is perfect substitutes, where the indifference curve is a straight line. In this case, the MRS does not change as the person receives more of one good relative to the other. The substitution effect in response to a change in relative prices is larger when the two goods are close substitutes than when they are close complements.
Chapter 2 Economists’ View of Behavior 59
close substitutes. For instance, a small price change can motivate a consumer to switch from one brand of orange juice to another if the consumer is largely indifferent between the two brands (i.e., they are viewed as close substitutes). Geometrically, as the convexity of an indifference curve increases, the consumer does not have to move as far from the initial optimum to reach the new optimum as relative prices change (higher convexity implies that the slope of the indifference curve is changing more rapidly along the curve).
Additional Considerations Our analysis has focused exclusively on interior solutions where the consumer opti- mally purchases positive quantities of both goods. This focus is justified because it is the usual case with convex indifference curves. Nevertheless, there are special cases where it is optimal for the consumer to spend the entire income on only one of the goods. This outcome is known as a corner solution. For example, in the case of perfect substitutes it is optimal for the consumer to purchase only one of the goods unless the budget line and straight-line indifference curve have the same slopes, in which case the consumer is indifferent between purchasing either of the two goods (and thus might purchase positive quantities of both goods). For instance, you might be relatively in- different between holding your cash as $5 bills or $10 bills at an exchange rate of two for one. However, you will hold only one type of bill at other exchange rates. If you have the ability to trade one $10 bill in the marketplace for three $5 bills you should clearly do so. Similarly, while you might be indifferent between purchasing two simi- lar brands of orange juice when they sell for identical prices, you will quickly shift to buying only one brand if that one goes on sale.
For simplicity we have focused on an example based on only two goods. When there are more than two goods in the marketplace, an increase in the price of one good can motivate a reduction in the demand for other complementary goods. For example, an increase in the price for playing golf can reduce the demand for golf equipment. The substitution effect constitutes movement away from golf-related goods to other goods, which are now relatively less expensive. We examine comple- mentarity and substitutability of products in greater detail in Chapter 4.
Calculus Derivation of Equal Marginal Principle The equal marginal principle states that the marginal utility to price ratio is equal for all goods at the consumer’s optimal consumption bundle. At any combination where this condition does not hold, the consumer can be made better off by making feasi- ble changes in the consumption bundle. This section provides a calculus-based de- rivation of this principle.
The utility function for the two-good case takes the following general form:
U � f (xi, xj) (2.21)
To find the slope of an indifference curve, we totally differentiate Equation (2.21). We set this differential equal to zero, since utility does not change along an indifference curve:
dU � [�U��xidxi] � [�U��xj dxj] � 0 (2.22) The slope of the indifference curve is defined by dxi�dxj (when good i is placed on the y-axis). Thus the
slope of the indifference curve � �(�U��xj)�(�U��xi) (2.23) � �MUj�MUi (2.24)
60 Part 1 Basic Concepts
This expression has a straightforward interpretation. For illustration, assume that at some fixed combination of xi and xj, the marginal utility of good i is 1 and the mar- ginal utility of good j is 2. This means that 2 units of i can be given up for 1 unit of j and utility will stay the same. This is true by definition, since j has twice the mar- ginal utility of i.
At a consumer’s optimum the slope of the budget line (–Pj�Pi) is equal to the slope of the indifference curve:
�MUj�MUi � �Pj�Pi (2.25)
Rearranging this expression yields the Equal Marginal Principle:
MUj�Pj � MUi�Pi (2.26)
This principle immediately generalizes to utility functions with more than two goods.
ANALYZING MANAGERIAL DECISIONS: Consumer Choice
1. Define the following terms: marginal utility, ordinal utility, marginal rate of substitution, equal marginal principle, demand function, substitution effect, income effect, normal good, inferior good, perfect complement, and perfect substitute.
2. Susan Pettit’s preferences for coffee (by the
pound) and doughnuts (by the dozen) can be
characterized as follows:
MUcoffee � MUx � y 2
MUdoughnuts � MUy � 2xy
a. If the ratio of relative prices is (Px�Py) � 6�3 � 2, and Susan’s income is $90 per period, what combination of pounds of
coffee and dozens of doughnuts will she
choose?
b. Now let the ratio of coffee to doughnut prices decline to unity (�1), holding the price of doughnuts constant. How does
Susan respond to the reduction in the
relative price of coffee?
c. Redo parts (a) and (b) for the case of income of $60 per period.
d. Derive Susan’s demand function for coffee. e. Is coffee a normal or inferior good for this
consumer?
f. Does Susan consider coffee and doughnuts to be either perfect complements or perfect
substitutes? Explain.
3. Susan’s demand function for coffee in the previ-
ous problem includes only the price of coffee
and income. Thus, changes in the price of
doughnuts do not affect the demand for coffee.
Does this imply that there is no substitution effect between the two goods? Explain.
4. (More challenging problem) Mario Casali is a
TV newscaster who gets an annual clothing
allowance to buy suits that he must wear
during his televised forecasts. He allocates the
allowance each year between expensive Italian
suits and cheap American suits. Mario’s utility
function for suits is SA.5 where S is the number of Italian suits bought and A is the number of American suits bought. Last year, Mario
bought two Italian suits and four American
suits. [Note: MUS � A .5 and MUA � .5SA
(�.5)]
a. If Mario was maximizing his utility last year, what was the ratio of the price of an
Italian suit to the price of an American suit
(PS�PA)? b. What was Mario’s clothing allowance last
year if the price of an Italian suit was
$1,000?
c. If Mario has the same allowance this year as last year, and American suit prices have
not changed, how high would the price of
Italian suits have to rise in order for Mario
to want to buy exactly one Italian suit this
year?
Chapter 2 Economists’ View of Behavior 61
Appendix B: Introductory economics generally concentrates on single-period problems. For ex- Inter-Temporal ample, how does a consumer choose to spend her income within a single period? Decisions and How much should a firm produce in a single period to maximize its profits? What
the Fisher prices should it charge for this output?
Separation The frameworks introduced in this book, however, also are used to analyze
Theorem multiperiod problems. Indeed, this is what the modern study of finance is largely about. How does an individual choose between consumption today versus saving for the future? How does a firm choose between paying cash dividends now versus in- vesting to earn higher future profits?
This appendix provides a simple example of how the consumer choice frame- work presented in this chapter can be used to analyze inter-temporal consumption decisions. It also provides a brief introduction to the important problem of a firm deciding on whether to pay higher cash dividends now or to invest the cash to earn higher profits in the future. In so doing, we introduce an important concept that is the starting point of the modern study of finance—the Fisher Separation Theorem.
Simple Example of Inter-temporal Choice Mary Donaldson graduated from college five years ago and has been working as an entry-level employee at a bank. She has taken leave from her job to enter a one-year, full-time MBA program, which begins today. The bank has paid for her tuition, books, and basic room and board. It has also promised to promote her when she com- pletes the program. While Mary earns no salary from the bank while she is in the pro- gram, the bank has promised to pay her $75,000 per year in her new position. Mary currently has $25,000 in savings.
Mary can borrow money from a bank at a 5 percent interest rate if she wants to consume more while she is in school than she can buy with her $25,000. For exam- ple, she might want to rent a better apartment than the one she has been provided. She also might want to travel internationally on her school breaks or to upgrade her music system or automobile. Alternatively, Mary might want to save all or part of her $25,000 so that she can consume more in the future. She knows that she will likely want to buy a house once she starts her new job. She will also have moving and other expenses that will not be covered by her company. She earns 5 percent interest on her savings.
Mary’s problem is to decide how much to consume today versus how much to consume in the future given her current savings, future income, and the market in- terest rate. The key insights that arise from analyzing this problem can be illustrated most conveniently by assuming that Mary cares only about consumption at two points in time: today and one year from today. (This simplification is similar to our earlier focus on only two goods—food and clothing.) To simplify the analysis fur- ther, we assume that there is no uncertainty about Mary’s future income of $75,000 and that she pays no taxes on her interest or job income.
If Mary saves all $25,000 over the next year, she will have (1.05 � $25,000) � $26,250 at the end of the year in her account. Added to her $75,000 salary, the max- imum sum she could have to spend next year is $101,250. Mary, however, might want to increase her current consumption at the cost of not being able to consume as much next year. If Mary wants to spend more than $25,000 today, she will have to borrow to do it. The bank will not loan Mary more money than she is able to pay
62 Part 1 Basic Concepts
back (with interest) given her future income of $75,000. The maximum (B) that she can borrow is
(1.05) B � $75,000
B � $75,000/1.05 � $71,428
Adding the maximum borrowing of $71,428 to the initial $25,000 gives Mary a max- imum of $96,428 to consume today, assuming she consumes nothing next year.
Mary is highly unlikely to want to consume all of her funds in just one period. Rather she is likely to want consume at least something in each period. We refer to her $25,000 in current savings and the $75,000 she will receive next year in income as her endowment. One option is for Mary to consume her endowment at the time it is received. In this way, she neither saves nor borrows. Depending on her prefer- ences, however, Mary might want to borrow something from the bank to consume more today or to save part of her $25,000 to consume more in the future.
The solution to Mary’s decision problem can be pictured using the graphical framework introduced in this chapter. Figure 2.15 displays Mary’s inter-temporal budget line. The variable on the y-axis is Mary’s consumption next year (c2); the
100 20 70 Consumption today (C1) in $000’s
Mary is a net saver
Mary is a net borrower
Mary’s inter-temporal budget line slope = –(1.05)
Endowment
0
C o
n su
m p
ti o
n i n
o n
e y
e a
r (C
2 )
in $
0 0
0 ’s
30 40 50 60 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
110
120
130
Figure 2.15 Mary’s Inter-Temporal Consumption Choice
Mary’s initial endowment consists of $25,000 in current savings and $75,000 in future income. The interest rate for borrowing and lending is 5 percent. The inter-temporal budget line shows all feasible combinations of consumption today and consumption next year, given Mary’s endowment and the interest rate. Mary’s optimal choice is where the budget line is tangent to an indifference curve. The figure depicts two possible optima that assume different preferences for Mary. The one on the left is the case where she is a net saver. She saves part of her initial $25,000 so that she can increase her consumption in the second period. The one on the right shows the case where she borrows against her future income to increase her current consumption. The actual outcome depends on Mary’s particular preferences.
Chapter 2 Economists’ View of Behavior 63
variable on the x-axis is her consumption today (c1). The budget line goes through her endowment and shows all the feasible alternatives that Mary has, given her en- dowment and the 5 percent interest rate. The y-intercept of $101,250 is the maximum amount she can consume next year if she chooses to consume nothing today. The x-intercept of $96,428 is the maximum she can consume today if she chooses to consume nothing next year. The slope of the budget line is �1.05, which more generally can be expressed as �(1 � r), where r is the interest rate. Note that a change in the interest rate will change the slope of the budget line. An increase would make the line steeper, while a decrease would make it flatter. In all cases the line would include the endowment point.
Mary’s preferences can be pictured with standard indifference curves. All combi- nations of c1 and c2 along a given indifference yield the same level of utility. Mary’s optimal consumption choice occurs at the point of tangency between her budget line and an indifference curve (assuming an interior solution). Mary would like to be on an even higher indifference curve, but this is the best she can do, given her endow- ment and the interest rate of 5 percent. Whether Mary decides to borrow or save de- pends on her preferences. Figure 2.15 depicts two possibilities. The tangency on the left occurs at a point where Mary is a net saver (she saves part of her $25,000 to in- crease next year’s consumption); the tangency on the right shows the case where Mary is a net borrower (she borrows to consume more today at the cost of not being able to consume as much next year). Which of these, if either, that she will choose depends on Mary’s particular preferences for inter-temporal consumption.
Exercise for the Reader. As previously noted, a change in the interest rate will change the slope of the budget line. This, in turn, will change Mary’s optimal choice. Use the standard choice diagram depicted in Figure 2.15 to demonstrate each of the following: If Mary is a borrower when the interest rate is 5 percent, she will also be a borrower if the interest rate falls to 3 percent. However, if Mary is a borrower at 5 percent and interest rate rises to 7 percent, she may still be a borrower, but she might decide to switch to being a lender. Now suppose that Mary is a lender at the initial 5 percent rate. What will she do if interest rates rise? What if they fall?
Terminology. The maximum that Mary can borrow, given her future income of $75,000, is $71,428 at the 5 percent interest rate. In the business world, the $71,428 is referred to as the present value of the $75,000 future cash flow. It is the amount that Mary would need today to obtain $75,000 in one year investing at the market in- terest rate of 5 percent. The ability to earn 5 percent on her savings implies that Mary would be indifferent between receiving $71,428 today or $75,000 one year from now (since she could reproduce the $75,000 future cash flow with $71,428 today). The process of transforming future cash flows into present values is called discounting. The present value in this example was obtained by dividing the $75,000 by 1.05. More generally the present value of a cash flow, C, occurring one year in the future is C/(1 � r), where r is the annual interest rate.32 The $75,000 cash flow in this ex- ample is the future value of the $71,428.
32Calculating present vales is a bit more complicated when expected future cash flows occur at multiple dates
in the future and when they vary in their riskiness. However, the basic concept is the same. A dollar today is
worth more than a dollar in the future (since you could obtain the same dollar in the future by investing a
smaller amount today).
64 Part 1 Basic Concepts
Fisher Separation Theorem Now consider an inter-temporal investment decision by a firm. Deon and Ramona each own 50 percent of the firm. The firm has $100,000 in cash that it could distrib- ute to the owners as cash dividends. This would give Deon and Ramona additional cash today. Alternatively the firm could use the funds to invest in a project that would allow it to pay higher future dividends to its owners.
Our previous example suggests that individuals can differ in their inter-temporal consumption preferences (some might want to save for the future, while others might want to spend more on current consumption). An important question is whether the managers of the firm should consider Deon and Ramona’s time preferences in de- ciding whether to invest in the project. The somewhat surprising answer is that under certain assumptions the answer is no.
Modern finance courses typically start with the assumption of perfect capital mar- kets, which are characterized by zero transaction costs, no taxes, and perfect infor- mation. In a perfect market, Deon and Ramona will unanimously agree that the firm should invest in the project if it increases the present value of the firm’s cash flows, even if they have quite different time preferences. This important result is one part of what is known as the Fisher Separation Theorem—named after the economist Irving Fisher. The other implication, which focuses on how the project is financed, will be addressed later in this appendix.
The basic logic for why the firm’s investment decision can be separated from its owners’ preferences is as follows. If the firm invests the $100,000 today it will re- ceive $110,000 as a cash inflow in one year. For simplicity, assume the firm makes this investment, then (1) the investment is riskless (the firm will receive the $110,000 for sure) and (2) the firm will discontinue operations at the end of the year and dis- tribute $55,000 each to Deon and Ramona. Alternatively, the firm might forgo the investment, discontinue operations and pay $50,000 to each of the owners in cash dividends today. We assume for this analysis that the firm, Deon, and Ramona can all borrow or lend at a market interest rate of 5 percent (subject to having the funds to pay back loans with interest).
If the firm decides to liquidate and pay $100,000 in cash dividends, the present value of the firm’s cash flows is by definition $100,000 (since the cash flows occur at the present time). The present value of $110,000 received in one year is $110,000/1.05 � $104,762. According to the Fisher Separation Theorem, both Deon and Ramona will want the firm to invest regardless of their inter-temporal preferences for consumption since it increases the present value of the firm’s cash flows.
To see why, suppose that Deon wants to consume all he can today, while Ramona wants to save all she can today to consume more in the future. If the firm invests in the project, it will be able to pay $55,000 to each owner in one year. Deon can bor- row $52, 381 from a bank using his future $55,000 as collateral ($52,381 � 1.05 � $55,000). In contrast if the firm does not make the investment, Deon will only have the current dividend of $50,000 to consume today—a loss of $2,381 in current con- sumption. Ramona, in turn, could borrow nothing today and have $55,000 to spend next year if the firm decides to invest. If instead the firm discontinues operations today, she will only have (1.05) � $50,000 � $52,500 to consume next year—a loss of $2,500 in future value. The difference is due to the fact that the firm can earn 10 percent on its investment, compared to the 5 percent that Ramona earns from per- sonal savings. The conclusion is that Deon and Ramona will both want the firm to invest even though they have dramatically different time preferences.
Chapter 2 Economists’ View of Behavior 65
Large corporations often have thousands of shareholders. The basic result illus- trated in this simple two-person example, however, readily extends to many joint owners. In a perfect capital market, all owners will unanimously agree that the firm should invest in any project that will increase the present value of its cash flows. The owners, in turn, can use their own borrowing and lending in capital markets to meet their individual inter-temporal preferences.
Financing Decision. The second part of the Fisher Separation Theorem focuses on the firm’s financing decision. According to the Fisher Separation Theorem, the fi- nancing decision does not affect value in a perfect capital market and is therefore ir- relevant. In other words, the firm’s financing decision can be separated from its in- vestment decisions. The investment decision should be based on present value, while the financing decision is irrelevant in a perfect market. In our current example, this implies that it would not matter whether the firm forgoes its current dividend and uses the $100,000 to finance the investment (as analyzed above) or pays the $100,000 in current dividends and borrows $100,000 to finance the investment.
The logic for this result can be illustrated by comparing how Deon and Ramona would fare if the firm were to borrow to finance the investment in the case analyzed earlier, where the project was financed by forgoing current dividends. If the firm pays the $100,000 it has on hand in current dividends and borrows $100,000 to fund the investment, it will have to pay $105,000 back to the lender in a year. Since its cash flow from the project is $110,000, it will have $5,000 leftover to distribute to Deon and Ramona in one year as dividends. If Ramona invests the initial $50,000 cash dividend at 5 percent, she will have $52,500 at the end of the year in savings plus the $2,500 dividend that she will receive at that time. The total of $55,000 is ex- actly the same as when the firm paid no dividends and used its own cash to fund the project. Thus, Ramona is indifferent as to how the project is financed. Similarly under the second option, Deon could borrow $2,500/(1.05) = $2,381 to finance cur- rent consumption (using his future dividend of $2,500 as collateral). Added to the $50,000 current cash dividend, he will have $52,381 to spend today—the same amount that he would have if the firm financed the investment with cash and paid no current dividends. Deon is also indifferent as to which of the two financing options the firm chooses.
Modern finance theory starts with this perfect capital market analysis. The as- sumptions of zero transaction costs and perfect information are then relaxed to ex- amine under what circumstances the Fisher Separation Theorem breaks down. The analysis focuses on whether there are “real-world” circumstances where the owners of the firm can disagree on a firm’s investment decisions or where the financing de- cision affects firm value? The answer to these questions is yes, but answering them is beyond the scope of this book.
chapter
3 C H A P T E R O U T L I N E
Goals of Economic Systems Property Rights and Exchange in a Market Economy
Dimensions of Property Rights Gains from Trade
Basics of Supply and Demand The Price Mechanism Shifts in Curves versus Movements along Curves Using Supply and Demand Analysis for Qualitative Forecasts Linear Supply and Demand
Supply and Demand— Extended Analysis
Price versus Quantity Adjustments Short-Run versus Long- Run Effects Industry Cost Increases and Price Adjustments
Prices as Social Coordinators Efficient Exchange and Production Measuring the Gains from Trade Government Intervention Externalities and the Coase Theorem
Markets versus Central Planning
General versus Specific Knowledge Knowledge Creation Specific Knowledge and the Economic System Incentives in Markets
Contracting Costs and Existence of Firms
Contracting Costs in Markets Contracting Costs within Firms
Managerial Decisions Summary Appendix: Shareholder Value and Market Efficiency
M uch of the world’s economic activity occurs within “free mar- kets” where individual decisions are coordinated through the price mechanism. For example, four of the countries with the largest gross domestic products (GDPs) in 2012 (the United
States, Japan, Germany, and France) all have developed market systems. China with the second largest GDP has made increased use of markets since the 1990s. Prior to that time it had been a centrally planned economy with an extremely low per capita GDP.
On closer inspection, however, it is evident that a substantial amount if not most of the production in modern economies takes place inside firms, where multimillion dollar resource allocation decisions (e.g., on what to produce and how to produce it) are made by managers without the use of market transactions. The monetary size of the world’s largest firms exceeds that of many economies. For instance, the 2012 GDPs of Peru, Kenya, and Portugal were $205 billion, $41 billion, and $212 billion, respectively; the 2012 net sales of ExxonMobil, Walmart, and Chevron were $453 billion, $447 billion, and $246 billion, respectively.
Exchange and Markets
L E A R N I N G O B J E C T I V E S
1. Illustrate the concept of Pareto efficiency. 2. Explain the role of alienable private property rights in markets and why
voluntary trade takes place.
3. Define and apply the concept of comparative advantage. 4. Explain the difference between demand and supply functions versus demand
and supply curves.
5. Distinguish between movements along supply and demand curves and shifts in the curves.
6. Explain the forces that move prices and quantities toward their equilibrium lev- els in a competitive market.
7. Explain why long-run demand and supply curves are generally more elastic than short-run curves.
8. Predict (qualitatively) the relative changes in price versus quantity when demand or supply changes in applied settings.
9. Define and interpret consumer and producer surplus; define and interpret dead- weight loss in terms of the value of foregone gains from trade.
10. Explain the effects of price controls both within the supply and demand model and in real-world terms.
Chapter 3 Exchange and Markets 67
To be effective, managers must have a working understanding of both markets and firms. In this chapter, we contribute to this understanding by examining five impor- tant questions: Why do most people actively participate in market exchanges? How do market systems work? What is supply and demand analysis and how can it be used by managers? What are the relevant advantages of using market systems com- pared to central planning in large economies? Why do we observe so much economic activity conducted within firms in market economies?
Answers to these questions are particularly important to managers for two rea- sons. First, an understanding of how markets work helps managers make appropriate strategic and operational decisions (e.g., input, output, and pricing decisions). The supply and demand analysis that we introduce in this chapter is especially useful in many management applications. Second, understanding the relative advantages and disadvantages of markets, central planning, and firms is directly relevant to under- standing firm-level issues such as which decision rights to be decentralized to employees and whether to make or buy each of the firm’s inputs. The basic tools and concepts introduced in this chapter are used to analyze these specific management decisions in more depth in subsequent chapters.
Goals of Economic Systems Every economic entity—be it a national economy, firm, or household—is confronted with three basic issues:
• What to produce
• How to produce it
• How to allocate the final output
Economic entities can be organized in alternative ways to address these issues. For instance, national economies can rely on either central planning or free markets. Similarly, firms and households can use centralized decision making, where the CEO or head of household makes all major decisions. Alternatively, other people in the firm or household can be granted substantial decision-making authority.
Given the alternatives, what is the best way to organize economic activities? To answer this question, we need some criterion for comparing alternative systems. Un- fortunately, uniform agreement over such a criterion is unlikely. For instance, you might argue that an ideal system would produce your preferred mix of products and give them all to you—although your neighbor would certainly disagree. Given these differences in opinion, economists generally focus on a relatively uncontroversial but narrow criterion for comparing the effectiveness of economic systems: Pareto efficiency.1 The production and distribution of goods and services in an economy is said to be Pareto-efficient if there exists no alternative that keeps all individuals at least as well off but makes even one person better off. If an economic system is not producing or distributing goods efficiently, it is conceptually possible to make its members better off by adopting Pareto-improving changes (thus benefiting some members without hurting others).
To illustrate the concept of Pareto efficiency, suppose that an economy can pro- duce two goods: desktop and tablet computers. Currently the economy is producing
1The term is named after Vilfredo Pareto, 1848–1923, an Italian economist and sociologist.
68 Part 1 Basic Concepts
1,000 desktops and 2,000 tablets. The two goods are being produced efficiently only if it is impossible to increase the production of one of the goods without decreasing the production of the other (given existing technology and resources). In contrast, suppose that some of the firms that are currently producing desktops are wasting raw materials due to suboptimal production methods (e.g., the firms could be scrapping more metal than necessary because of the way they cut metal sheets into final parts). In this case, the firms could increase their production of desktop computers by choosing more effective production methods without having any effect on the num- ber of tablets that are being produced. Doing so would be a Pareto improvement. The distribution of desktops and tablets (once they are produced) among consumers in this economy is Pareto efficient if there is no alternative distribution that keeps all individuals at least as well off but makes even one person better off.
As example of inefficient distribution, suppose that John owns a tablet but prefers a desktop, while Gunter owns a desktop and is indifferent between owning a tablet or a desktop. The current allocation is not Pareto efficient since John would be made better off if he and Gunter were to exchange the two products, while Gunter would be no worse off. The trade would be Pareto improving. If a change in the allocation of the two goods in the economy adversely affects even one person, the move would not be Pareto-improving and an economist would have little formal basis to conclude whether the move would be good or bad for society at large.2
Within centrally planned economies, government officials decide what to pro- duce, how to produce it, and who obtains the final output. In free markets, these de- cisions are decentralized to individuals within the economy. At least in concept, a central planner could order any feasible production and distribution of goods. Thus, any allocation of resources that could be achieved by a market economy also could be achieved by a centrally planned economy—at least in principle. We begin by dis- cussing how market systems work and how they can produce a Pareto-efficient allo- cation of resources. We then discuss why in large economies a market is more likely to produce an efficient resource allocation than central planning.
Property Rights and Exchange in a Market Economy A property right is a legally enforced right to select the uses of an economic good. A property right is private when it is assigned to a specific person. Private property rights are alienable in that they can be transferred (sold or given) to another individ- ual. For example, if Valerie Fong owns an automobile, she can use the automobile as she sees fit (within limits set by traffic laws). Valerie can restrict others from using her vehicle. She also can sell the automobile (transfer to another person whatever property rights her ownership confers in the vehicle). The government maintains police and a court system to help enforce these property rights.
An important feature of a market economy is the use of private property rights. Owners of land and other resources have the legal rights to decide how to use these re- sources and frequently trade these rights to other individuals. They are free to start new
2Therefore, economics does not address the question of which of the many possible efficient resource
allocations is best for a society. Producing your preferred set of products and giving them all to you is
efficient (the allocation cannot be changed without making you worse off). However, others will argue that
the allocation is not fair or equitable. Economists have no special training in resolving these fairness or equity
issues. Thus, we focus our attention on efficiency, which most people will agree is a laudable objective—
given limited resources it is good not to waste them.
businesses and to close existing businesses. In contrast, in centrally planned economies, property tends to be owned by the state; government officials decide how to use these resources.
Dimensions of Property Rights
Ownership involves two general dimensions: use rights and alienability rights. These aspects of ownership are not always bundled together. You own your body in the sense that you can decide what activities to pursue. Yet, there are significant legal restrictions on alienability. For instance, you cannot enter a legally enforceable con- tract to sell one of your kidneys, despite the fact that you have two, can live com- fortably with one, and might value your second kidney much less than a wealthy in- dividual who is dying from kidney failure. This restriction eliminates the possibility of a free market in kidneys. In some transactions, it is possible to sell use rights while retaining alienability rights. For instance, in a rental contract, the renter obtains the rights to use an apartment, but does not own or have the right to sell the unit. Con- versely, the landlord has the right to sell the apartment, but does not have the right to use it during the term of the lease. (Rental, lease, and franchise agreements separate alienability and use rights; we examine these contracts in a later chapter.)
M A N A G E R I A L A P P L I C AT I O N S
Patent for Priceline.com Government-enforced patents better define property rights in new inventions. Patents in the United States are awarded
for processes, machines, manufacturers, or compositions of matter that are considered useful, novel, and not obvious.
Patents protect the intellectual property rights of the inventor and thus protect the common good by providing
incentives to innovate novel and not obvious inventions.
Priceline.com received a patent for the world’s first buyer-driven e-commerce system where users can go to the
Internet to name their price for goods and services. Expedia.com challenged whether Priceline.com’s process is really
novel and not obvious. In 2001, the parties settled. Internet businesses where consumers can name their own price have
to pay Priceline.com a royalty. This royalty is a tax on all Internet consumers. Awarding a patent for something that is
obvious lowers incentives for future innovations that use this process.
Source: J. Gurley (1999), “The Trouble with Internet Patents,” Fortune (July 19), 118; L. Flynn (2002), “The Web World Watches Closely as British Telecommunications Stakes a Patent Claim on a Now-Ubiquitous Function: Hyperlinking,” New York Times (March 11).
Chapter 3 Exchange and Markets 69
M A N A G E R I A L A P P L I C AT I O N S
Property Rights Insecurity in Colombia Colombia has a continuing stream of impoverished farmers who are leaving the countryside and migrating to cities.
They live in shantytowns that breed crime and violence. Yet Colombia has substantial arable land—an area equivalent
in size to North Dakota. And only about 20 percent is used for agriculture. These seemingly inconsistent facts are both
by-products of Colombia’s more than four decades long conflict between the government and a paramilitary force that
is deeply involved in drugs. The resulting violence induces many to flee. But others are forced off their land or
intimidated into selling at bargain-basement prices.
Source: J. Forero (2004), “Colombia’s Landed Gentry: Coca Lords and Other Bullies,” New York Times (January 21), A4.
70 Part 1 Basic Concepts
Gains from Trade
To understand how a market economy works, we must understand the motives for trading property rights. Why do people buy and sell? The basic answer is to make themselves better off.
Within the economic framework, people order their preferences and take actions that maximize their level of satisfaction (utility). Trade takes place because the buyer places a higher value on the item than the seller. The corresponding gains from trade make both parties better off—voluntary trade is mutually advantageous. For example, if José Coronas is willing to pay up to $26,000 for a particular automobile and Rochester Motors is willing to sell the automobile for as little as $20,000, the poten- tial gains from trade are $6,000 ($26,000 � $20,000). If the automobile trades at $23,000, both parties are $3,000 better off. José gives up $23,000 to buy something that he values at $26,000, while Rochester Motors obtains $23,000 for something it values at only $20,000. At other prices between $20,000 and $26,000, the total gains are still $6,000 but they are not split evenly. For example, at a price of $25,000, José gains $1,000 in value, while Rochester Motors gains $5,000.3
From where do these gains from trade come? One source is differences in prefer- ences. The buyer and seller simply may place different values on the traded item. For
3Sometimes, individuals regret a trade after the fact. For instance, José might be unhappy after he purchased
a particular automobile from Rochester Motors. But given the information he had at the time of the
transaction, he must have expected it to be advantageous to purchase the automobile or else he would not
have done so (at least from Rochester Motors). José’s ability to say no limits the extent to which he can be
exploited in any voluntary trade.
M A N A G E R I A L A P P L I C AT I O N S
While Animosity between the Governments of Venezuela and the United States Grows, So Does Trade Former Venezuelan President Hugo Chavez predicted that “capitalism will lead to the destruction of humanity.” In turn
he worked hard to redirect his nation’s trade away from the United States to what he considered “more like-minded
nations,” such as China and Iran. Washington has also taken steps to limit trade with Venezuela, such as halting
American weapon sales to Venezuela.
The potential gains from trade between Venezuela and the United States, however, are large. For example,
Venezuela is a leading producer of oil that is in high demand in the United States, while U.S. manufacturers produce
automobiles and other products that are in high demand in Venezuela. Meanwhile many Venezuelans place lower value
on an array of products produced by the like-minded nations, such as Chinese cars.
Despite the acrimony between the Venezuelan and U.S. governments, trade between the two countries continues to
soar. Venezuela is the fourth largest oil supplier to the United States, while non-oil exports to the United States
increased 116 percent during the first three months of 2006. Meanwhile, General Motors and Ford have been striving
to meet soaring demand in Venezuela, with automobile sales up over 28 percent between July 2005 and 2006. General
Motors, as Venezuela’s largest car manufacturer, indicated that it planned to invest $20 million to expand its output in
the country by 30 percent, adding 600 new workers.
Trading partners are made better off through exchange. There are strong incentives to engage in trade. This example
illustrates that these incentives are not easily thwarted by political rhetoric. Trade continues to thrive even though
companies and individuals face potential government actions that could affect their trading relationships and
corresponding investments.
Source: S. Romero (2006), “For Venezuela, as Distaste for U.S. Grows So Does Trade,” nytimes.com (August 16).
example, some people value new automobiles more than other people do. Another im- portant source of gains is that the seller may be able to produce the item more cheaply than the buyer and thus has a comparative advantage in its production. In advanced economies, individuals specialize in producing goods where they have a comparative advantage; they then trade to acquire other goods. Specialization greatly enhances the standard of living of a society. Imagine that you had to be completely self-sufficient, making your own clothing, growing your own food, building your own house, and producing your own vehicles for transportation. Your overall standard of living would be dramatically lower than it is living in a modern, specialized economy.
Table 3.1 presents a numerical example of comparative advantage. Donna Meyers and Mario Santini each produce their own food and drink through hunting and brew- ing beer. Panel A shows how many hours it takes for them to produce 1 pound of meat and 1 quart of beer. Panel B shows their allocation of time and resulting output work- ing independently prior to their meeting and trading. Both work 30 hours per week.
A. Time it takes for Donna and Mario to produce meat and beer
Meat (1 lb) Beer (1 quart)
Donna 1 hour 2 hours Mario 6 hours 3 hours
B. Allocation of time (30 hours per week) and output prior to specialization and trading
Meat Beer
Donna 18 hours; 18 lbs 12 hours; 6 quarts Mario 18 hours; 3 lbs 12 hours; 4 quarts Total production 21 lbs 10 quarts
C. Production with specialization
Meat (lbs) Beer (quarts)
Donna 30 0 Mario 0 10 Total production 30 lbs 10 quarts
D. One possible allocation after trading
Meat (lbs) Beer (quarts)
Donna 23 6 Mario 7 4
Table 3.1 Comparative Advantage
This table provides an example of comparative advantage. Panel A shows how many hours it takes for Donna and Mario to produce 1 pound of meat and 1 quart of beer. Donna and Mario each work 30 hours per week. Panel B shows their allocation of time and resulting output prior to meeting and trading. While Mario is less productive than Donna in an absolute sense for both goods, he has a comparative advantage in making beer (opportunity cost of 1⁄2 pound of meat for 1 quart of beer compared to Donna’s opportunity cost of 2 pounds of meat). Donna has a comparative advantage in producing meat. Panel C illustrates how total production can be increased by having both people specialize in the activity where they have a comparative advantage. Panel D displays a possible final allocation after Donna and Mario trade. Specializing and trading produce real gains for both people.
Chapter 3 Exchange and Markets 71
72 Part 1 Basic Concepts
Donna spends 18 hours per week hunting and 12 hours per week making beer, pro- ducing a total of 18 pounds of meat and 6 quarts of beer. Mario spends 18 hours hunt- ing and 12 hours making beer, producing a total of 3 pounds of meat and 4 quarts of beer. Their total production prior to meeting is 21 pounds of meat (18 � 3) and 10 quarts of beer (6 � 4).
Donna has an absolute advantage over Mario in making both goods—it takes her fewer hours to produce either a pound of meat or a quart of beer. Mario, however, has a comparative advantage (lower opportunity cost) for producing beer. Mario’s op- portunity cost for producing 1 quart of beer is 1⁄2 pound of meat (he could have pro- duced 1⁄2 pound of meat with the 3 hours he uses to produce a quart of beer), while Donna’s opportunity cost is 2 pounds of meat. Conversely, Donna has a comparative advantage in hunting. Donna’s opportunity cost for producing 1 pound of meat is 1⁄2 quart of beer, while Mario forgoes 2 quarts of beer to produce a pound of meat.
Panel C shows how total production can be increased by having each person spe- cialize in producing the product for which they have a comparative advantage. Donna can produce 30 pounds of meat by spending all 30 hours on hunting, while Mario can produce 10 quarts of beer by focusing exclusively on beer production. This specialization maintains total beer production at 10 quarts and increases the production of meat by 9 pounds.4 By specializing and trading, both parties can be made better off—there are gains from trade. The final allocation depends on the spe- cific bargain reached by Donna and Mario. One possible outcome is presented in Panel D, where both parties have the same amount of beer as before but more meat. Specializing and trading results in a Pareto improvement relative to working in isolation.
M A N A G E R I A L A P P L I C AT I O N S
Strategic Business Planning: Ignoring Economics of Trade During the 1970s, many firms adopted a particular form of strategic business planning. The idea behind this process is
to treat the projects of a firm like stocks in a portfolio. Through systematic analysis, winners are to be kept and losers
sold. Specifically, all projects of the firm are ranked based on growth potential and market share. Projects with high
growth potential and high market share are called stars, while projects with low growth potential and market share are
referred to as dogs. Dogs are sold, while stars are kept. Funding for the stars comes from cash cows, projects with high
market share and low growth potential. Thus, money is invested in the winners to enhance the firm’s competitive
advantage.
Although the idea might sound intriguing, its underpinnings are inconsistent with the basic economics of trade—
sell if, and only if, you can get a price that exceeds the value of keeping the item yourself. This principle implies that,
contrary to the process, dogs should be kept unless they can be sold at sufficiently high prices. Moreover, stars should
be sold if the price is sufficiently high.
By the 1980s, many firms found that violating the basic economics of trade had led them to accumulate suboptimal
collections of projects. Large increases in stock prices were observed as these firms reshuffled plants, divisions, and
subsidiaries through sell-offs, spin-offs, and divestitures.
Source: (1984) “The New Breed of Strategic Planner,” BusinessWeek (September 17), 62–68.
4In this example, Donna and Mario completely specialize and produce only one product. More generally, at
least one of the two people will specialize in producing one product. The other person might allocate some
time to producing the same product (the one for which he does not have a comparative advantage) if
additional gains are derived from producing more of the product than can be produced by the first person.
Figure 3.1 provides a graphical analysis of Mario and Donna’s gains from spe- cialization and trade. A Production Possibilities Frontier (PPF) shows all combina- tions of the two goods that can be produced with efficient production. Recall, with efficient production it is not possible to increase the production of one good without decreasing the production of the other. The figure pictures Mario and Donna’s indi- vidual PPFs, as well as their combined PPF that assumes appropriate specialization. The individual PPF ’s picture Donna and Mario production choices when each work independently with no trade. As drawn, Donna can produce both more beer and more meat than Mario if there is no trade.
The absolute value of the slope of Mario’s PPF, 1⁄2 lb. meat/qt. beer, is his oppor- tunity cost for producing beer. The absolute value of the slope of Donna’s PPF,
350 5 10 15 20 25 30
35
0
5
10
15
20
25
30
Beer (quarts)
M e a t (l b s.
)
No trade combined total
C om
bined production possibilities
curve (PPF)— efficient production
Mario's production possibilities (PPF)
D onna's production
possibilities (PPF)
Donna with specialization
and trade
Mario with specialization
and trade
Example of complete specialization (Depending on their preferences they may want to locate somewhere else on the combined PPF)
No trade
No trade
G a in
G a in
G a in
Figure 3.1 Comparative Advantage
This figure displays the example of comparative advantage presented in Table 3.1 graphically. Donna and Mario’s Production Possibilities Frontiers (PPFs) show the combinations of the two products that each can produce individually, working 30 hours per week with no trade. The absolute value of the slope of Mario’s PPF, 1⁄2 lb. meat/qt. beer, is his opportunity cost for producing beer. The absolute value of the slope of Donna’s PPF, 2 lb. meat/qt. beer, is her opportunity cost for producing beer. Mario’s lower opportunity cost implies that he has a comparative advantage in beer production. The combined PPF shows combinations of meat and beer production that are possible if they divide the work based on comparative advantage. Any point on the combined PPF is efficient in the sense that the output of one good cannot be increased without decreasing the output of the other good, given their productive capacities. The y-intercept of 35 is the maximum meat that can be produced if they produce no beer. Moving from there, the slope of the PPF is initially �1/2, which assumes Mario will produce the beer because of his comparative advantage. The kink in the PPF occurs where Mario reaches his maximum production of 10 beers. Donna must produce any desired beers beyond that point, and she has a higher opportunity. The combined and individual gains from specialization and trade are also pictured.
Chapter 3 Exchange and Markets 73
74 Part 1 Basic Concepts
2 lb. meat/qt. beer, is her opportunity cost for producing beer. Mario’s lower oppor- tunity cost implies that he has a comparative advantage in beer production. The ini- tial production choices with no trade are pictured on the respective PPFs. The com- bined PPF shows combinations of meat and beer production that are possible if they divide the work based on comparative advantage. The y-intercept of 35 is the maxi- mum amount of meat that can be produced jointly if they produce no beer. Moving from there to positive beer production, the slope of the PPF is initially �1⁄2, which assumes Mario is assigned the task of producing beer because of his comparative advantage.
The kink in the PPF occurs where Mario reaches his maximum production of 10 beers for the week. Donna must produce any additional beers beyond that point, and she has a higher opportunity cost. The slope of the PPF from that point on is �2. Ar- rows showing the increased amount of meat that goes to each person (without re- ducing the beer they receive) picture the combined and individual gains from spe- cialization and trade. These gains are based on the assumption of complete specialization and Donna trading Mario 7 lbs. of meat for six beers. Where the two will actually produce on the PPF depends on their preferences for beer and meat. In simple two good examples of this type with linear PPFs, it is never optimal for both people to produce both goods. It, however, can be optimal for one person to be com- pletely specialized and the other person to produce some of both goods, depending on the demand for the two products.
While it is possible to have an absolute advantage in producing all goods, it is im- possible to have a comparative advantage in all activities.5 Specialization and trading are common features in economies throughout the world. Comparative advantage also arises in many management situations. For example, while a top-level manager might be able to perform many activities more effectively and in less time than a lower- level employee, the manager should not try to do all activities himself (make sales calls, work on the manufacturing line, change lightbulbs, answer phones, and so on). More value will be created if managers concentrate on activities for which they have a com- parative advantage.
5Note for the mathematically inclined: Donna’s opportunity cost for producing 1 pound of meat is 1⁄2 quart of
beer (1 qt. beer/hr.)/(2 lb. meat/hr.) � 1⁄2 qt. beer/lb. meat. The reciprocal of this ratio, 2 lb. meat/qt. beer, is
Donna’s opportunity cost for producing beer expressed in pounds of meat. If Donna’s ratio is smaller than
Mario’s ratio for one product, the reciprocal of Mario’s ratio must be smaller than the reciprocal of Donna’s
ratio. Thus Donna has a comparative advantage in producing the first product, while Mario has a comparative
advantage in producing the second product. It is a mathematical impossibility for one person to have a
comparative advantage in producing all products.
Gains from Trade In 1880, the United States was about to become the world’s most efficient economy. Yet labor productivity varied
substantially among states. North Carolina, the least productive state, was only 18 percent of Nevada, the most
productive. (In 1880, Nevada’s productivity was high because many had migrated there to work in the mines.) In 2002,
New Mexico, the poorest state, had a per capita income that was almost 60 percent of Connecticut, the richest state. As
a giant free-trade zone, incomes in the United States have converged to similar standards. Although there are still
differences, those differences have fallen substantially—and not at the expense of the rich states.
Source: V. Postrel (2004), “A Case Study in Free Trade: American Incomes Converge, but Not at the Bottom,” New York Times (February 24), C2.
A C A D E M I C A P P L I C AT I O N S
A common misconception is that trade takes place because people have too much of some goods—people sell to others what they cannot use themselves. This view, however, does not explain why individuals sell houses, cars, jewelry, land, and other resources that they value highly and have in short supply. The economic explanation for trade argues that trade takes place not because people have too lit- tle or too much of a good. Rather, trade takes place because a person is willing to pay a higher price for a good than it is worth to its current owner. While you might love your new sports car, you would still sell it if someone offered you a high- enough price. And winning bidders of collectibles auctioned on eBay are fre- quently individuals with collections of related items.
It is important to recognize that trade is an important form of value creation. Trading produces value that makes individuals better off. Gains from trade also pro- vide important incentives to move resources to more productive uses. If George Nichols can make the most productive use of a piece of land, he will be willing to pay a higher price for the land than other potential users. The current owner, Jody Crowe, has the incentive to sell the land to George, because she gets to keep the pro- ceeds from the sale. It is these incentives that help to promote a Pareto-efficient al- location of resources in a market economy. After all mutually advantageous trades are completed, it is impossible to change this allocation without making someone worse off.
Basics of Supply and Demand Gains from trade explain why individuals buy and sell. But what coordinates the sep- arate decisions of millions of individuals in a market economy to prevent chaos? Why are there not massive surpluses of some goods and huge shortages of other goods? What restricts the amounts demanded by the public to the amounts supplied? Answers to these questions come from an understanding of the market price system.
ANALYZING MANAGERIAL DECISIONS: Comparative Advantage in the Workplace
You are a manager of a division of a company that
is responsible for the final assembly of two com-
puter products, modems and keyboards. You man-
age two employees, Julio and Chenyu, who each
work 8 hours per day. Currently you have assigned
both Julio and Chenyu to spend the first 7 hours of
the day assembling keyboards and the last hour as-
sembling modems. Julio can assemble 2 modems
per hour and 14 keyboards per hour. Chenyu is
more highly skilled in both activities. She averages
3 modems per hour and 15 keyboards per hour.
1. How many modems and keyboards are being
assembled under the current work assign-
ments?
2. What are Julio’s opportunity costs for assem-
bling modems and keyboards? What are
Chenyu’s? Does either employee have a
comparative advantage in assembling one
of the products?
3. Devise a way of reassigning the work activi-
ties between the two employees that keeps the
number of modems being assembled the
same as before but increases the number
of keyboards.
4. What are potential reasons why you might not
want to change the work assignments (assume
that more assembly of either or both products
is desirable)?
Chapter 3 Exchange and Markets 75
76 Part 1 Basic Concepts
The Price Mechanism
The basic economics of a price system can be illustrated through standard supply and demand diagrams. Figure 3.2 displays a supply and demand diagram for a particular model of personal computer—for example, a Pentium dual-core machine with standard quality and features. The vertical axis on the graph shows the price for a PC, and the horizontal axis shows the total quantity of PCs demanded and supplied in the market for the period (e.g., a month).
The market includes all potential buyers and sellers of this type of PC. Suppose that in this market there are many buyers and sellers and that individual transactions are so small in relation to the overall market that the price is unaffected by any single sale or purchase. In this case, no buyer or seller has market power: All trades are made at the going market price. We label this type of market as competitive.
The demand curve depicts how many total PCs consumers are willing to buy at each price (holding all other factors constant). The demand curve slopes downward because consumers typically buy more if the price is lower. For example, consumers are likely to buy more PCs if the price is P LO (say, $900) than if the price is P HI (say, $1,500).
The supply curve depicts how many PCs producers are willing to sell at each price (holding all other factors constant). The curve slopes upward: At higher prices, pro- ducers are able and willing to produce and sell more units. For example, at a price of $900, many potential producers cannot cover their costs, and thus they refrain from entering production. At a price of $1,500, more units are manufactured and brought to market.
P ri ce
( in
d o lla
rs )
Demand
Supply
Q
Surplus
Shortage
P HI
P *
P LO
Q *
$
Quantity of PCs
Figure 3.2 Supply and Demand in the PC Industry
The demand curve shows the number of PCs that consumers want to purchase at each price. The supply curve shows the number of PCs that producers want to sell at each price. Equilibrium occurs where the two curves intersect. Here, the quantity supplied equals the quantity demanded. If the price is above the market-clearing price of P*, say at PHI, there is a surplus of PCs. Producers supply more PCs than consumers want to purchase, and inventories build. If the price is below the market-clearing price, say at PLO, there is a shortage. Producers supply fewer PCs than consumers want to purchase and inventories shrink. Surpluses and shortages put pressure on prices and quantities to move to equilibrium levels of P*.
The two curves cross at the market-clearing price P* and quantity Q*. At the mar- ket-clearing price, the quantity of PCs demanded exactly equals the quantity sup- plied. Here, at a price of $1,200, the market is said to be in equilibrium.
There are strong pressures within markets that push prices and quantities toward their equilibrium levels. To see why, suppose that the market price is above the equi- librium price, such as P HI in Figure 3.2. At this higher price, there is a surplus of PCs—suppliers produce more PCs than consumers are willing to purchase. As inven- tories of unsold PCs build, this surplus places downward pressure on prices as suppli- ers compete to try to sell their products. As prices fall, fewer PCs will be produced and more will be demanded, thus reducing the surplus. In contrast, if the price is below the market-clearing price, such as P LO in Figure 3.2, inventories dwindle and back orders accumulate—there is a shortage of computers. Here, consumers will bid up the price of PCs as they compete for the limited supply. As prices rise, producers increase their output and consumers demand fewer PCs, thus reducing the shortage. When the mar- ket is in equilibrium, there is no pressure on prices and quantities—the quantity de- manded exactly equals the quantity supplied. Inventories are stable at their desired levels, and the market price is stable at this point.
Supply and demand diagrams like that in Figure 3.2 are snapshots at a point in time. As time passes, both the supply and the demand curves are likely to change. Figure 3.3 shows the effects of a shift in the demand curve in the PC market. The left panel depicts an increase in demand. Here, there is a shift in the demand curve to the right, since at each price, consumers demand more PCs. Demand for PCs might increase for a variety of reasons, including an increase in the purchasing power of consumers or a decline in the prices of supporting software. These types of changes motivate consumers to purchase more PCs at any given price. After the demand shift at the old equilibrium price, inven- tories shrink and there is a shortage of PCs. This shortage places upward pressure on prices; higher prices in turn stimulate more production. The end result is a higher equi- librium price and quantity. The right panel shows that the opposite effect occurs with a reduction in demand. This shift to the left in the demand curve also can be caused by a variety of factors (e.g, a recession that causes businesses to reduce their purchases of PCs or an increase in personal tax rates that reduces consumers’ purchasing power).
Chapter 3 Exchange and Markets 77
Q
Initial demand
Initial demand
$
P ri ce
( in
d o lla
rs )
$
Increase in demand Decrease in demand
Q
S 0 S0
D1
D2 D0
Q0 Q0Q1 Q2
D0
Quantity of PCs Quantity of PCs
*
P1 *
P0 *
* **
*
P0
P2
*
Figure 3.3 The Effects of a Shift in Demand on the Equilibrium Price and Quantity of PCs
The initial equilibrium is where the demand curve, labeled D0, intersects the supply curve, labeled S0. The left panel shows the effects of an increase in demand. The result is a higher equilibrium price and quantity. The right panel shows the effects of a decrease in demand. The result is a lower equilibrium price and quantity.
78 Part 1 Basic Concepts
Figure 3.4 depicts the effects of a shift in supply in the PC market. The left panel displays a shift in the supply curve to the right. A rightward shift implies an increase in supply, because at each price producers make and offer more PCs. Many factors might cause an increase in supply. For example, a decline in the prices of labor and other inputs used for manufacturing PCs will make PC production more profitable and increase supply. Supply also might increase because of changes in technology that allow for less expensive, more efficient production. After the supply shift at the old equilibrium price, inventories accumulate and there is a surplus of PCs. This sur- plus places downward pressure on prices, which in turn increases the quantity of PCs demanded. The end result is a lower equilibrium price and higher equilibrium quantity. The right panel shows that the opposite effect occurs when supply shifts to the left.
Initial supply
P ri ce
( in
d o lla
rs )
Initial supply
Q
P *1
D 0
S0 S2
S1 S0
D0
P *0
Increase in supply Decrease in supply
P *2
P *0
Q
$ $
Quantity of PCs Quantity of PCs
Q0 Q0Q1 Q2 * * **
Figure 3.4 The Effects of a Shift in Supply on the Equilibrium Price and Quantity of PCs
The initial equilibrium is where the demand curve, labeled D0, intersects the supply curve, labeled S0. The left panel shows the effects of an increase in supply. The result is a lower equilibrium price and an increase in equilibrium quantity. The right panel shows the effects of a decrease in supply. The result is a higher equilibrium price and a lower equilibrium quantity.
M A N A G E R I A L A P P L I C AT I O N S
Shifts in Demand, Quantity, and Price at the PGA Tournament The PGA Tournament features competition among the world’s top golfers. In 2013, the PGA was held at Oak Hill
Country Club in Rochester, New York. The event attracted over 30,000 spectators a day. Many of these spectators were
from outside the Rochester area.
A significant number of these visitors were avid golfers who wanted to play while they were in Rochester.
Rochester has several courses that are open to the public. However, many courses in the area are private (only members
and their guests can play). Facing this dramatic temporary increase in the demand for public golf courses, several of
the private courses decided to become public during the week of the PGA. These courses charged high fees ranging
from $150 to $350 per round (their normal guest fees were approximately $75). This example highlights that shifts in
demand motivate increases in the quantity supplied and the price of a product (in this case, golf times).
Chapter 3 Exchange and Markets 79
Shifts in Curves versus Movements along Curves
Demand and supply curves depict the quantities that will be demanded and supplied at each possible price, holding all other relevant variables constant. The price observed in the market determines the specific quantity demanded and quantity supplied in the marketplace (i.e., the price determines the relevant points on the two curves).
We have provided examples of how a change in an important non price variable can cause either the demand and/or supply curve to shift. It is common to refer to a rightward shift in the demand curve as an increase in demand and a leftward shift as a decrease in demand. Similarly, a rightward shift in the supply curve is referred to as an increase in supply (higher quantity is supplied at any given price) and a left- ward shift as a decrease in supply.
A movement along a given demand or supply curve is caused by a change in price (holding other variables constant). The change in price is said to result in a change in the quantity demanded or quantity supplied.
It is important to be able to distinguish between shifts in demand and supply curves (changes in demand or supply) and movements along a given curve (changes in quantity demanded or quantity supplied). For example, reconsider the increase in supply pictured on the left in Figure 3.4. As we have discussed, this increase would have been motivated by a change in some relevant variable other than the price of the product, such as a decline in the hourly wage paid to labor. The rightward shift in supply indicates that producers will supply more of the product at any given price. The demand curve has not changed, so there is no change in demand. However, there is a change in the quantity demanded when supply increases—at the lower equilib- rium price consumers purchase more of the product.
Note that a change in supply or demand is motivated by a change in a relevant variable other than the price of the good. On the other hand, a change in the quantity demanded or quantity supplied is caused by a change in the price of the good, in- duced by a shift in the other curve, holding all other variables that affect the position of the curve constant.
Using Supply and Demand Analysis for Qualitative Forecasts
Consulting firms, large companies, and governmental agencies use formal statistical analysis to develop quantitative estimates of demand and supply to use in analyzing specific markets. Managers, analysts, the media, and others, however, often use sup- ply and demand analysis on a much less formal basis simply to forecast the direction of changes in prices and quantities in the marketplace.
For example, suppose that Mr. Fan owns a restaurant chain in the United States that features a menu of specialty beef dishes. Fan has just read in his morning news- paper that there have been newly reported cases of “Mad Cow Disease” in the United States. Several people who ate contaminated beef died recently from the disease. Fan recalls that Japan, South Korea, and other countries immediately stopped importing American beef when the first case of Mad Cow disease was reported in the United States a number of years ago. Among other things, Fan wants to know what effect the scare will have on the price that he will have to pay for beef over the upcoming months.
Fan can use supply and demand analysis to forecast the directional effect that the Mad Cow scare will have on beef prices. First, he needs to consider whether it will
80 Part 1 Basic Concepts
affect the demand for beef, the supply of beef or both. He is fairly confident that the scare will cause demand to decrease. As pictured in Figure 3.3, a decrease in demand is expected to result in a lower price for beef. However, Fan should not forget supply. For example, what if the government immediately ordered the slaughter and disposal of 90 percent of all cows in the United States to protect consumers from the disease? He needs to take both effects into account, unless he has good reason to assume that one of the effects is not likely to be important.
For practice, suppose that you are Fan and use supply and demand analysis to forecast the directional change in the price beef. Start by drawing a standard supply and demand diagram, as pictured in Figure 3.2 to depict the beef market prior to the scare. Draw the projected shifts in supply and demand caused by the scare. Note that the shifts in both curves have the same directional effect in reducing the equilibrium quantity. The effects on price, however, are in opposite directions. In such cases, you need to ask yourself, which effect is likely to be larger? Sometimes it is hard to fore- cast. Suppose in this case, Fan is relatively confident that the short-term supply of beef will not change very much. The government is unlikely to order the mass de- struction of cows due to a few reported cases of the disease. If so, he might assume that the demand effect is likely to dominate and the near-term effect is likely to be a decline in beef prices. In the longer run, the cost of cattle ranching and beef process- ing could increase due to new government regulations, additional testing for Mad Cow disease, and so on. Thus the longer run effects are harder to forecast. For addi- tional practice, what affect do you think the scare will have on the price of chicken products?
Fan is also likely to be interested in how the scare will affect customer demand for his beef dishes. Demand for products is the subject of the next chapter.
Linear Supply and Demand
Throughout this book we use linear demand and supply curves (as pictured in Fig- ures 3.2 to 3.4). Linearity simplifies the analysis and is often a reasonable approxi- mation in actual applications (at least over the range of actions being considered). This section provides a numerical example of supply and demand analysis using lin- ear supply and demand curves.
Suppose that the supply function for apples is
Qs � 30 � 0.2Pa � 3W (3.1)
where Qs is the quantity supplied of apples in millions of pounds, Pa is the market price for apples in cents, and W is the hourly wage rate paid to agricultural workers. The supply function indicates that farmers will produce more apples as either the market price of apples rises or the wage rate for workers falls. Farmers produce more apples when the wage rate falls since production costs are lower. Currently the wage rate is $10. Substituting this value in Equation (3.1) and solving for Pa produces the current supply curve
6:
Pa � 5Qs (3.2)
6Recall that when graphing the supply and demand curves, the convention is to place price on the vertical axis.
Chapter 3 Exchange and Markets 81
Supply curves show the relation between price and quantity supplied holding all other factors constant (in this case the wage rate for agricultural workers).
Suppose that the demand function for apples is
Qd � 20 � 1�3Pa � 0.002I (3.3)
where I � per capita income. The demand function indicates that consumers will purchase more apples as the price falls and/or as income increases. Currently income is $10,000. Substituting this value into the demand function and solving for Pa pro- duces the current demand curve:
Pa � 120 � 3Qd (3.4)
In equilibrium, the quantity supplied equals the quantity demanded: Qs � Qd � Q* where Q* denotes the equilibrium quantity. Substituting Q* into the supply and demand curves (Equations [3.2] and [3.4]) and setting them equal (since there is one equilibrium price) allows us to find the equilibrium quantity, Q*:
5Q* � 120 � 3Q* (3.5) Q* � 15
The equilibrium price of 75 cents is found by substituting the equilibrium quantity of 15 into either the demand or supply curve Equations ([3.2] or [3.4]).7
ANALYZING MANAGERIAL DECISIONS: Ethanol and Pork Prices
Over the past decade, the federal government has
taken significant steps to encourage the develop-
ment of ethanol and other fuels made from plants
as a partial replacement for gasoline. These actions
have been undertaken by politicians in the midst of
public concerns about the dependence on foreign
oil, war in the Middle East, and global warming.
The primary input for ethanol production is corn.
In 2011, the 13.9 billion gallons of ethanol pro-
duced in the United States consumed over 20 per-
cent of the domestic corn supply.
Suppose that the government has just passed
new legislation mandating increased annual pro-
duction of corn ethanol. You manage the Hog
Heaven restaurant chain. Your restaurant chain,
which has about 300 outlets throughout the United
States, specializes in barbecue pork dishes but also
offers chicken, beef, and vegetarian meals. Cur-
rently about 80 percent of your revenue comes
from your pork dishes. The price of pork has a
major impact on your costs. You are concerned
that the federal promotion of ethanol might have
an impact on pork prices and the profitability of
your restaurant chain. Feed cost is typically about
50 to 60 percent of the total cost of production of
pork producers. About 80 percent of the feed that
hogs consume is corn.
1. Use basic supply and demand analysis to illus-
trate the likely effect of the government’s man-
dated increase of ethanol production on (1)
corn prices and (2) pork prices.
2. What actions might you consider given the
results of your analysis?
7We could have found the equilibrium price by setting the demand and supply functions (Equations [3.1] and
[3.3]) equal after substituting for the current values of W and I. The equilibrium quantity then could be found by substituting the equilibrium price into either Equation (3.1) or (3.3). We took the extra steps of solving for
the demand and supply curves to illustrate how they are derived from the underlying demand and supply
functions. We elaborate on this derivation in the case of the demand curve in the next chapter.
82 Part 1 Basic Concepts
Note that changes in the wage rate shift the supply curve, while changes in income shift the demand curve. See if you can find the new equilibrium price and quantity if income increases to $20,000. Answer the problem before looking in this footnote for the answer.8
Determining the equilibrium in simple numerical supply and demand problems can be summarized as follows. Begin by inserting the current values for variables other than price into the supply and demand functions and solve the functions for P to get the demand and supply curves. Equate the supply and demand curves and solve for the equilibrium quantity, Q*. Put Q* into either the supply or demand curve equations and solve for the equilibrium price, P*.
To consider the effect of a change in a non price variable, replace the original value with the new value and repeat the above steps to obtain the new equilibrium. It is a good idea to graph these kinds of problems on a standard supply and demand diagram, which shows the original equilibrium, as well as the shift in the relevant curve and the new equilibrium. Graphical analysis can often provide a more intuitive understanding of a problem. It also can be helpful as a check for arithmetic errors that can arise in purely algebraic solutions to the problem.
Supply and Demand—Extended Analysis This section uses supply-and-demand framework to analyze other issues of manage- rial interest. It begins by considering whether a change in supply or demand is likely to have a greater impact on the equilibrium price or quantity. This analysis is followed by a related discussion of short-run versus long-run responses to changes in the marketplace. The section ends by considering under what circumstances a per- unit cost increase in an industry can be passed on to consumers through higher prices.
Price versus Quantity Adjustments
We have seen that the equilibrium price and quantity typically change when either the demand or supply curves shifts. Forecasting the direction of price and quantity changes in a market can be very useful to managers. However, it is even more useful to be able to forecast whether most of the impact of the change will be on price or quantity.
To analyze this question, we need to introduce the concept of demand and supply elasticities. Elasticities, which are defined more precisely later in this book, measure the sensitivity of quantity demanded and supplied to price changes.9 The left panel of Figure 3.5 depicts two extreme demand curves—one is vertical and the
8An increase in income in this example shifts the demand curve to the right, resulting in both a higher
equilibrium price and quantity (see Figure 3.2). More specifically, shifting the income from $10,000
to $20,000 results in an equilibrium quantity of 22.5 million pounds and an equilibrium price of $1.125
(112.5 cents). 9The responsiveness of consumption and production decisions to price changes varies across products. For
example, consumers tend to be relatively responsive to price changes when it comes to restaurant meals but
pay little attention to changes in the price of toothpaste. Similarly, the supply decisions of producers can be
greatly affected by price in some cases and vary little in others (in the latter case consider a farmer who has
grown a fixed quantity of a highly perishable commodity that must be sold before rots).
other is horizontal. The right panel displays similarly sloped supply curves. A ver- tical curve indicates that the quantity demanded or quantity supplied is the same regardless of price. Vertical supply and demand curves are referred to as perfectly inelastic. The horizontal curves depict the extreme opposite case where no quantity is demanded at prices above P*, and no quantity is supplied at lower prices. Horizontal supply and demand curves are referred to as perfectly elastic. Typically industry demand curves and supply curves are less extreme—industry demand curves typically slope downward, while industry supply curves typically slope up- ward. At a given price and quantity, demand and supply curves with more vertical slopes are referred to as relatively more inelastic (since the relative change in quantity to a price change is small), while flatter curves are termed relatively more elastic.
In extreme cases, a change in demand or supply will result in only a price or quantity change—the other variable will remain unchanged. Figure 3.6 depicts these cases for an increase in demand. When supply is completely inelastic, an in- crease in demand increases price, but has no effect on quantity. For example, con- sider land in central New York City. Its supply is inelastic and the price for the land is determined by demand. The higher the demand, the higher will be the price. In contrast, when supply is perfectly elastic the increase in demand will cause an increase in quantity but no increase in price. Later in this book, we will discuss why horizontal long-run supply curves are reasonably common in certain types of industries.
P ri ce
( in
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0 0
10987654321 Quantity
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P ri ce
( in
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10987654321 Quantity
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Perfectly inelastic supply
Perfectly elastic supply
Perfectly inelastic demand
Perfectly elastic demand
Figure 3.5 Perfectly Inelastic and Elastic Demand and Supply
This figure displays perfectly inelastic and elastic demand and supply curves. When demand (supply) is perfectly inelastic the quantity demanded (supplied) does not change with price. With perfectly elastic demand (supply), a small increase (decrease) in price relative to $5 in this figure will reduce the quantity demanded (supplied) to zero.
Chapter 3 Exchange and Markets 83
84 Part 1 Basic Concepts
Figure 3.7 depicts the two extreme cases for an increase in supply. The effects are similar to what we saw for the increase in demand. An increase in supply will be fully reflected in price when demand is perfectly elastic and fully in quantity when demand is perfectly elastic. In the next chapter, we will examine in more detail the determinants of demand elasticities.
We have focused on increases in demand and supply. The effects are the same but in the opposite direction for decreases in supply and demand. While we have focused our attention on the extremes, the results generalize to more common in-between cases. If the supply curve is relatively inelastic, a change in demand will primarily affect the price of the product. In contrast, if the supply curve is relatively elastic a change in demand will primarily affect the quantity. Similarly, if the demand curve is relatively inelastic a shift in supply will be reflected primarily in price; if the demand curve is relatively elastic it will primarily affect the quantity.
Short-Run versus Long-Run Effects
Supply and demand curves tend to be relatively more inelastic in the short run than the long run. To see why, consider how consumers might respond to a large increase in the price of gasoline. Consumption of gasoline might not change very much in the
100 1 2 3 4 5 6 7 8 9
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3
4
5
6
7
8
9
Quantity
P ri ce
( in
d o lla
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Perfectly inelastic supply
Perfectly elastic supply
D1
D2
Increase in demand
Figure 3.6 Increase in Demand with Perfectly Inelastic or Elastic Supply
This figure displays the effect of a demand increase on the equilibrium price and quantity when supply is either perfectly inelastic or elastic. The original equilibrium price and quantity are $5 and 4 units respectively. When demand increases, only the equilibrium price changes when supply is perfectly inelastic (from $5 to $7). With perfectly elastic supply, only the equilibrium quantity changes (from 4 to 6). If demand were to decrease back to D1, the same general effects would happen in reverse.
first weeks after the price increase. People have to get to work, school, and other places. The locations of people’s homes and the types of automobiles they drive are largely fixed in the short run. All of these factors make the short-run demand rela- tively inelastic. With more time to adjust, however, consumers can reduce their con- sumption of gasoline by forming car pools with others to commute to work, pur- chasing vehicles that get better gas mileage, and so on. In the even longer run, they can relocate moving closer to their jobs, change jobs to work at locations closer to home, and so on. A similar analysis holds on the supply side of the market. Supply curves tend to be relatively more inelastic in the short run than the long run because suppliers have more flexibility to make changes over the longer run. Figure 3.8 depicts supply curves and demand curves for the so-called short run, medium run, and long run. Focus on the intersection point of the three curves as the initial starting price and quantity. Notice how a change in price is met with a greater change in quantity in the longer run, since the curves are more elastic.
We previously discussed how a shift in demand or supply will have a greater ef- fect on price when the other curve is relatively inelastic and a greater effect on quan- tity when it is relatively elastic. Because demand and supply curves are likely to be more inelastic in the short run than the long run, shifts in demand and supply will tend to be reflected in price changes in the short run and in quantity changes in the long run.
100 1 2 3 4 5 6 7 8 9 Quantity
Perfectly inelastic demand
Perfectly elastic demand
S1
S2
Increase in supply
10
0
1
2
3
4
5
6
7
8
9
P ri ce
( in
d o lla
rs )
Figure 3.7 Increase in Supply with Perfectly Inelastic or Elastic Demand
This figure displays the effect of a supply increase on the equilibrium price and quantity when demand is either perfectly inelastic or elastic. The original equilibrium price and quantity are $5 and 4 units respectively. When supply increases, only the equilibrium price changes when demand is perfectly inelastic (from $5 to $3). With perfectly elastic demand, only the equilibrium quantity changes (from 4 to 6). If supply were to decrease back to S1, the same general effects would happen in reverse.
Chapter 3 Exchange and Markets 85
86 Part 1 Basic Concepts
Prices communicate important information to consumers and suppliers. For exam- ple, price increases signal to consumers to reduce their consumption of a product and to producers to figure out how to supply more of it. Ultimately, these responses trans- late into less extreme price changes and greater quantity changes in the longer run. In a sense, the large price changes in the short run help to motivate the output and con- sumption changes in the long run.
Industry Cost Increases and Price Adjustments
John MacDonald manages a company in a competitive industry that bottles and sells healthy juices to consumers. The current market price for juices in his industry is $5 per bottle. The government has just announced a new $2 per bottle tax that it is going to impose on suppliers in this industry. John wants to know whether he will be able to pass this cost increase on to consumers, for example, by charging $7 per bot- tle. Since his firm operates in a competitive industry he has no power to set the price. His hope is that the market price will increase to $7 to offset the cost increase. The question is will it? It turns out that the answer depends on the relative elasticities of supply and demand curves in the industry.
Figure 3.9 displays a graphical analysis of this example where the absolute values of the slopes of the demand and supply curves are roughly the same. The $2 per unit
M A N A G E R I A L A P P L I C AT I O N S
Decrease in Supply of Pilots Results in Reduction of Flights and Small Increases in Pilot Wages In August 2013, the Federal Government increased the minimum experience required for commercial airline pilots
from 250 hours to 1,500 hours. This reduced the supply of entry-level pilots materially. The primary employer of entry-
level commercial pilots are the smaller regional airlines. Before this change, the starting salary paid at 14 U.S regional
carriers averaged about $22,400 per year.
Supply and demand analysis suggests that this decrease in the supply of pilots would either decrease the number of
pilots employed by the airlines, increase pilot wages, or some combination of both. Many of the routes flown by the
regional airlines were only marginally profitable, and the airlines had only limited power to increase ticket prices to
cover the increased costs for hiring pilots. These conditions imply that their demand for pilots would have been
relatively elastic. The supply and demand framework predicts that the primary effect of a decrease in supply with
relatively elastic demand would be a decline in the number of flights by these smaller regional airlines. Consistent
with this forecast, many of the regional airlines cut their number of flights and hired fewer pilots, rather than
raising wages of entry-level pilots. In the first quarter of 2014. Silver Airways announced that it was cutting its flights
by 13 percent. Republic Airways, one of the nation’s largest regional carriers announced due to the limited lumber of
qualified commercial pilots, it was removing 27 of their 243 aircraft from operation. Great Lakes Aviation Ltd. stated
that it was reducing the number of pilots from 300 in 2013 to about 100. However this reduction in the supply of
qualified pilots, also resulted in small increases in pilot wages by 2014. For example, Silver Airways, a Florida-based
airline with 35 planes, offered its current pilots salary increases of 5 to 10 percent and promised a $6,000 bonus if they
continued to work for the company for one year.
Consistent with the economic view of behavior, some regional airlines responded “creatively.” Because the new
federal rules only required 250 hours of experience for commercial pilots flying planes with fewer than 10 seats they
could hire pilots with this lower level of experience by removing 10 seats from a 19-seat airplane. Since these pilots
were more plentiful, they were less expensive to hire.
Source: J. Nicas and S. Carey (2014), “What Can New Pilots Make? Near Minimum Wage” The Wall Street Journal (February 12).
cost increase causes the supply curve to shift upward by $2. Suppliers have to pay $2 per unit to the government and thus require $2 more per unit to induce them to bring any specific quantity to the market, relative to the original supply curve. For example, suppliers were willing to bring 6,000 units to market at a price of $5. Now they require $7 to induce them to produce the same quantity. Note that the decrease in supply (upward/leftward shift in the curve) causes the price to increase to $6. Thus, suppliers are able to pass on half the cost to consumers. John and the other producers collect $6 for each unit sold. However, they only net $4 after paying the tax to the government. Each side of the market is $1 per unit worse off.10
More generally the sharing of a per-unit cost increase depends on the relative elas- ticities of the demand and supply curves. In the previous example, the supply and de- mand elasticities were about the same, so each side of the market bore about one-half the cost. When the two elasticities are not the same, the side of the market with the less elastic curve bears the larger share of the cost increase. Figure 3.10 depicts the two extreme cases for the demand curve. If the demand curve is perfectly inelastic, quantity remains unchanged and the price increases by the full amount of the cost
100 1 2 3 4 5 6 7 8 9 Quantity
Long-run supply
Medium-run supply
Short-run supply
Medium-run demand
Short-run demand
Long-run demand
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Figure 3.8 Short, Medium, and Long Run
This figure displays the typical pattern observed for supply and demand curves in the short, medium, and long run. Both demand and supply tend to be more elastic in the longer run than the short run because consumers and producers have more time to make adjustments in quantities when price changes.
Chapter 3 Exchange and Markets 87
10Aside from paying the increase costs on units transacted, consumers and producers also experience lost
gains from trade due to the reduction in quantity transacted. Their combined loss due to the reduction in
trade is pictured by the deadweight loss (DWL) triangle in the graph. The tax does not only transfer money
from consumers and producers to the government, but also causes a reduction in quantity and gains from
trade. These losses are not offset by gains to others and so are commonly referred to as “deadweight losses.”
88 Part 1 Basic Concepts
increase. Here the entire cost increase is passed on to consumers. In contrast, when demand is perfectly elastic the price remains the same and the quantity adjusts. In this case, none of the cost increase is passed on to consumers. Similarly, it can be shown that if supply is perfectly inelastic, producers bear all the costs. If supply is perfectly elastic all the cost is passed on to consumers. When neither side of the
10 11 12 130 1 2 3 4 5 6 7 8 9 Quantity (000’s)
$2 per unit tax
D
S1
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Borne by consumers Borne by producers
DWL
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Figure 3.9 Passing on Part of a Cost Increase to Consumers
This figure displays an example where suppliers face a new $2 per unit tax. The original equilibrium price and quantity were $5 and 6,000, respectively. The tax causes the supply curve to shift upward by $2. The new equilibrium price and quantity are $6 and 4,000 units, respectively. Consumers pay $6, but producers only net $4 after tax. Each side of the market is $1per unit worse off than before the tax. The government collects $8,000 in taxes. The shaded rectangles reflect the sharing of this cost. Each side of the market bears $4,000, so the cost increase is evenly split. The even split is due to the fact that the absolute values of the slopes of the supply and demand curves in this example are equal. More generally, the side of the market with the relatively less elastic curve will bear a greater share of a per unit cost increase. The deadweight loss triangle represents the lost gains from trade due the quantity reduction due to the tax.
M A N A G E R I A L A P P L I C AT I O N S
Supply of Online Résumés Bogs Down Employers The Internet has reduced significantly the cost of submitting résumés to would-be employers. Job seekers no longer
must print their résumés on high-quality paper, address, stamp, and mail an envelope. A click of the mouse and the
résumé is gone. Some companies have thousands of résumés dumped into their e-mail boxes each day. During 1999
there were almost 5 million résumés on the Internet—200 times more than in 1994. When the cost of producing a good
(like submitting a résumé) falls, its supply increases.
Source: S. Armour (1999), “Online Résumés Bogging Down Employers,” Democrat and Chronicle (July 19), 1F.
10 11 12 130 1 2 3 4 5 6 7 8 9 Quantity (000’s)
Perfectly elastic demand
Perfectly inelastic demand
S1
S2
$2 per unit tax
New equilibrium with elastic
demand
New equilibrium with inelastic
demand
Tax borne by consumers with inelastic demand
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Tax borne by suppliers with Elastic demand
Figure 3.10 Sharing of a Cost Increases at the Extremes
This figure shows the effects of a $2 per unit cost increase with perfectly inelastic and perfectly elastic demand. When demand is perfectly inelastic, the entire cost increase is passed on to consumers through a higher price and quantity does not change. With perfectly elastic demand the entire cost is borne by suppliers (none can be passed on). Price does not change and quantity falls.
M A N A G E R I A L A P P L I C AT I O N S
Elastic Demand Limits Steelmakers’ Abilities to Pass through Cost Increases Higher prices for inputs, such as iron ore and coking coal, were expected to force up steel prices during 2011. Analysts,
however, predicted that steelmakers would be unlikely to be able to raise steel prices enough to pass on the full increase in
costs. Theory suggests that the ability of producers to pass through cost increases depends on the elasticity of demand.
Analysts argued that weaker demand from the construction industry and the expectation that China might tighten its
monetary policy due to concerns about rising inflation implied that steel makers would have difficulty in maintaining higher
prices throughout the year. A UBS analyst summarized the basic economics of the situation as follows, “While mills can
easily pass through higher input costs when demand is strong, unfortunately the current environment is less supportive.”
Source. D. Maylie (2010), “Steelmakers Grapple with Price-Increase Pressures,” The Wall Street Journal (December 28)
Chapter 3 Exchange and Markets 89
market is at one of the extremes, the cost is split. The side of the market with the rel- atively more elastic curve bears a smaller share of the cost.
Sometimes a cost increase is imposed on consumers, rather than on suppliers. For ex- ample, some states impose taxes on consumers when they purchase bottles of liquor at a store. While we do not do so here, it is relatively easy to show that the sharing of a cost increase does not depend on which side of the market initially incurs it. When a cost in- crease is imposed on consumers, the demand curve shifts downward, while the supply curve stays the same. The resulting price change results in the same net outcome for both parties as when the tax is imposed on suppliers. What matters in both cases are the relative elasticities of the supply and demand curves.
90 Part 1 Basic Concepts
Prices as Social Coordinators The equilibrium of supply and demand highlights the crucial role that prices play in coordinating the consumption and production decisions of individuals. For example, if too few PCs are being produced, inventories will shrink and dealers will raise prices. High-prices signal would-be producers to shift from producing lower-valued products to producing computers. Because property rights are private, individuals reap the reward from redirecting their efforts and therefore have strong incentives to shift production. Higher prices also motivate consumers to reduce the quantity of PCs demanded. The end result is that the quantity demanded equals the quantity supplied. This is what Adam Smith referred to as “the invisible hand.”
Efficient Exchange and Production
If everyone trades in a competitive marketplace and all mutually advantageous trades are completed, the price system results in a Pareto-efficient resource allocation.11
No government intervention or central planning is required. Rather, consumers and producers, acting in their own self-interest, react to price signals in a manner that produces an efficient resource allocation. Prices act to control and coordinate the many individual decisions made in the economy. After trading is completed, the output mix and final distribution of products cannot be changed without making someone worse off.
The basic logic for efficiency in a competitive economy is straightforward. At equilibrium prices, the quantity supplied equals the quantity demanded for all goods and there are no shortages or surpluses. Everyone who wants to make trades has done so, and all gains from trade have been exhausted. In making supply decisions, firms have strong private incentives to adopt the most efficient production methods and the value-maximizing output mix (these production choices maximize their profits). No changes in either production or distribution can be made without making someone worse off.
Measuring the Gains from Trade
In some applications it is useful to have measures of the gains from trade that are in units, such as dollars, that are independent of individuals’ subjective utilities. Con- sumer surplus and producer surplus display this property and are commonly used to measure the gains from trade and the effects of specific actions and events on con- sumers, producers, and society as a whole.12
Figure 3.11 displays supply and demand curves for a market in which the equilib- rium price and quantity are $10 and 10 units. The demand curve indicates that some
11These conditions will be met in a competitive market when trading costs are sufficiently low. Later, we will
discuss factors that can motivate inefficiency in a market economy. 12Technically, consumers must have a specific type of utility function for consumer surplus to be an exact
measure of their gains from trade in a market. However, it is generally a good approximation whenever
consumers allocate their expenditures across many goods, which most do. The measure is widely used and
accepted by most economists.
consumer would be willing to pay $19 to obtain the first unit of the product; how- ever, the consumer only has to pay the market price of $10. The $9 “surplus” is a measure of the consumer’s gains from trade from purchasing the first unit. The sum of the surplus at all points along the demand curve up to the equilibrium quantity of 10 units represents the aggregate difference between what consumers would be will- ing to pay for the product and what they have to pay given the market price. We call this difference, consumer surplus and display it graphically in Figure 3.11 by Triangle A. In this example, the consumer surplus is $50 (1�2 � 10 � 10). Note that in the aggregate, consumers would be willing to pay up to $150 dollars to obtain the 10 units (Triangle A � Triangle B � Triangle C), but only have to pay $100 (Trian- gle B � Triangle C). Their gains from trade from participating in this market are $50.
The same idea is used for measuring the net gains to producers. Later in this book, we show that the area under the supply curve represents the incremental costs that producers incur to produce the output. In this example, the incremental costs are $50 (Triangle C). Producers are willing to supply 10 units as long as the incremental rev- enue is at least equal to the incremental costs of $50. Producers, however, receive $100 (Triangle B � Triangle C). The extra $50 (Triangle B) represents the gains to trade for producers and is called producer surplus.
The total gains from trade produced in the market are measured by the sum of consumer and producer surplus. In this example, the total gains from trade (surplus) are $100 (Triangle A � Triangle B). We use the concepts of producer, consumer, and total surplus in several places in this book to measure the effects of various actions on consumers, producers, and “social welfare.”
Government Intervention
We have discussed how a well-functioning price system can produce an efficient al- location of resources without government intervention or central planning. Nonetheless, governments sometimes intervene to establish caps or floors on
$10
$20
Demand
SupplyConsumer surplus (Triangle A)
Producer surplus (Triangle B)
Incremental production costs (Triangle C)
Q 10
P
A
C
B
Figure 3.11 Consumer and Producer Surplus
In this figure, consumers pay $100 to obtain 10 units of the product ($10 � 10 units). They would have been willing to pay an additional $50 to obtain the 10 units. This $50 ( Triangle A) represents the gains from trade to consumers and is called consumer surplus. Producers receive $100 of revenue, but would have been willing to supply the product if they had covered their incremental production costs of $50 ( Triangle C). The extra $50 ( Triangle B) is the gains from trade to producers and is called producer surplus.
Chapter 3 Exchange and Markets 91
92 Part 1 Basic Concepts
prices. This section examines the economic effects of these actions (in an otherwise well-functioning market).
Price Controls The average retail price for gasoline in the United States was about $1.15 per gallon in 2003. Gasoline prices increased dramatically over the period 2004–2008 due to factors such as the increased demand for oil in China and India, the war in Iraq, and Hurricane Katrina. Gasoline prices, which averaged $1.60 per gallon in 2004, broke the $2.00 per gallon barrier in July of 2005. In August 2005, gasoline supply was dis- rupted by Katrina, the devastating storm that hit the Gulf Coast. Gasoline prices surged to over $3.00 per gallon. In subsequent months gasoline prices were volatile, rising from a low of $2.10 per gallon in November 2005 to a high of $3.20 per gallon in May 2007. In 2008 the price was above $4.00 per gallon. Consumers expressed fear and outrage over the high gasoline prices. Some groups asked the U.S. government to implement price controls to protect consumers from “unfair” gasoline prices.
Figure 3.12 displays the economic effects of a cap on the price of gasoline. The free market equilibrium price is $3.00 per gallon. However, suppose that the government passes a law that does not allow stations to charge more than $2.00 per gallon. At the $2.00 price, the quantity demanded, QD, is greater than the quantity supplied, QS — there is a shortage of gasoline. The excess demand implies that gasoline must be al- located through nonprice mechanisms. One mechanism is to serve customers in the order that they arrive until the supply is exhausted. This mechanism is likely to
$3
$2
Demand
Supply
Excess demand (shortage) for gasoline
$2 price
Q QDQS
$/Gallon
C B
Lost gains from trade
A
Figure 3.12 Economic Effects of a Government Price Cap on Gasoline
The free market equilibrium price in this figure is $3 per gallon. The government does not allow stations to charge more than $2 per gallon. At the $2 price, the quantity demanded is greater than the quantity supplied— there is a shortage of gasoline. The excess demand implies that gasoline must be allocated through nonprice mechanisms, such as waiting in line. Triangles A and B represent the lost gains from trade to consumers and producers (consumer and producer surpluses), respectively, induced by the price cap. Rectangle C represents a transfer of surplus from producers to consumers (ignoring other costs imposed on consumers). The price cap can also distort incentives of consumers to reduce consumption of gasoline, for example, by moving closer to work or buying smaller automobiles.
produce long lines and waits for gasoline. Also, customers who place the highest value on the gasoline (e.g., due to the importance of their travel) do not necessarily re- ceive the product. The quantity supplied falls as a result of the price cap, resulting in lost gains from trade (total surplus). The reduction in consumer surplus and producer surplus is pictured by Triangles A and B, respectively. The consumers who obtain the gasoline for $2.00 potentially benefit from the cap at the expense of the gasoline deal- ers, the gasoline distributors, the gasoline refiners, and the individuals who own the mineral rights and receive a lower price for the quantity sold (unless the gains are off- set by costs such as having to wait in line). Rectangle C pictures the transfer from pro- ducers to consumers (ignoring other costs).
During the 1970s, there was a severe shortage of gasoline in the United States due to an oil embargo and price controls. People still remember the long gas lines and substantial inconveniences experienced during that period. Some gas stations served customers based on their license plate numbers—odd numbers one day and even numbers the next. Customers also were limited in the number of gallons that they could purchase. These inconveniences have rarely been observed since the elimina- tion of price controls in the early 1980s.
Consumers responded to higher gasoline prices during the 2004–2007 period in a variety of ways. Some reduced their travel plans, while others shifted to less expen- sive forms of transportation (e.g., carpooling, buses, and bikes). Some moved closer to work, while others purchased more fuel-efficient automobiles. Price controls not only produce shortages, but also distort incentives to take actions that reduce the consumption of the product.
Price Floors A prominent example of a price floor is a minimum wage law. In the United States, the Fair Labor Standards Act (FLSA) requires employers to pay employees at least a minimum wage (in 2014, $7.25 per hour) for all hours they work. If a state has a min- imum wage that is higher than the federal minimum, employers are obligated to pay the higher rate to employees working in that state. For example, the minimum wage in the State of Washington was $9.32 per hour in early 2014.
Figure 3.13 displays the economic effects of a minimum wage law. The market clearing price for unskilled labor in this example is $6.00 per hour. However, em- ployers are not allowed to pay wages below $7.25 per hour. At $7.25, the quantity supplied of labor, QS, is greater than the quantity demanded, QD —there is unem- ployment. Firms would hire more workers at $6.00 and fewer people would enter the labor market; at $6.00, the quantity supplied equals the quantity demanded, Q*, and there is no unemployment.13
The QD people who are employed at the minimum wage of $7.25 benefit from the law at the expense of their employers who have to pay higher wages (unless the employees incur offsetting costs to obtain and keep their jobs). Rectangle C pictures the transfer of surplus from employers to employed workers. In contrast, the people between QD and Q* are hurt by the law. These people are willing to work for as lit- tle as $6.00 per hour and would obtain jobs in a free market. However, they are un- employed due to the minimum wage law. Overall, there is a reduction in the total gains from trade in the labor market. The lost surpluses for firms and labor are
Chapter 3 Exchange and Markets 93
13In reality, measured unemployment would not be zero absent minimum wage regulation. There are always
going to be individuals changing jobs or searching for better jobs. We abstract from these considerations in
this example.
94 Part 1 Basic Concepts
pictured by Triangles A and B, respectively. These triangles depict the lost surplus from not allowing companies and unemployed workers to enter into mutually beneficial employment relations below the minimum wage. In January 2014, the unemployment rate among teenagers in the United States was 22.6 percent com- pared to 6.8 percent for adults. One potential reason for the high unemployment rate among teenagers is the minimum wage.14
Minimum wage laws can also affect how people are paid. For example, suppose that prior to a new minimum wage law unskilled workers are paid $6.00 per hour plus health benefits. One likely effect of forcing employers to pay higher cash wages is a reduction in health benefits. Employees who prefer the health benefits to higher cash wages are worse off after the law.
14The U.S. government has tried to reduce the effects of the minimum wage law on teenagers by exempting
them from the law for their first 90 days of employment. During this period, teenagers must be paid at least
$4.25 per hour. Note that the amount of unemployment caused by the minimum wage laws depends on the
slopes of the supply and demand curves (see Figure 3.13). Although most economists would agree with the
direction of the effect, there is disagreement as to its magnitude. Many economists believe this effect is large,
but some disagree. For example, D. Card and A. Krueger (1995), Myth and Measurement: The New Economics of the Minimum Wage (Princeton University Press: New Jersey).
$7.25
$6.00
Labor demand
Quantity of labor
Labor supply
Minimum wage
QSQ *QD
W a g e (
$ /h
r. )
C
B
A
Lost gains from trade (surplus)
Unemployment (excess supply
of labor)
$
Q
Figure 3.13 Economic Effects of Minimum Wage Laws
This figure displays the supply and demand for unskilled labor. The free market equilibrium is a $6.00 wage rate and Q* people being hired. The government has imposed a minimum wage of $7.25 that results in an excess supply of labor (unemployment). The QD people who are employed at the minimum wage of $7.25 benefit from the law (unless they incur offsetting costs to obtain and keep their jobs). Rectangle C represents the transfer of surplus from employers to employed workers. In contrast, the people between QD and Q* are hurt by the law. These people are willing to work for as little as $6.00 per hour and would obtain jobs in a free market. However, they are unemployed due to the minimum wage law. Overall there is a reduction in the total gains from trade in the labor market. The lost surpluses from reduced trade for firms and labor are pictured by Triangles A and B, respectively.
Externalities and the Coase Theorem15
Externalities exist when the actions of one party affect the well-being or production possibilities of another party outside an exchange relationship. Externalities can pre- vent a free market from being efficient. If a firm emits pollution into the air, it can adversely affect the welfare of the firm’s neighbors. If the firm does not bear these
15This section draws on R. Coase (1960), “The Problem of Social Cost,” Journal of Law and Economics 3, 1–44.
The Coase Theorem and the “Fable of the Bees” A prominently discussed case of externalities is the so-called “Fable of the Bees.” Beekeepers provide pollination
services for the surrounding fruit growers, and the growers, in turn, provide nectar for the bees. Many economists
would consider this to be a classic case of externalities. If beekeepers and growers do not receive compensation for the
benefits they bestow on other parties, they will underinvest in their activities (from a social standpoint).
The Coase Theorem suggests that beekeepers and growers can privately negotiate to overcome this externality
problem. This is exactly what is done. Beekeepers and growers often enter into contracts. Fruit growers hire beekeepers
to supply hives of bees for pollination of those trees that give little suitable nectar, while the beekeepers pay growers for
the privilege of “grazing” their bees on high nectar-producing trees. Given these payments, beekeepers and growers
have incentives to consider the effects on the other party when they make their investment decisions. Through this
process, beekeepers and growers can reach efficient levels of investment without help from the government.
Source: S. Cheung (1973), “The Fable of the Bees: An Economic Investigation,” Journal of Law and Economics 16, 11–34.
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Chapter 3 Exchange and Markets 95
CBO Estimates Effects of Proposed Increase in the Federal Minimum Wage The Federal Minimum wage was $7.25 per hour in 2014. The President and various members of Congress supported
proposed legislation that would have increased it to $10.10 per hour. They argued that $7.25 was not a “living wage”
and that raising the minimum wage would lift many out of poverty. Opponents argued that by decreasing the number of
jobs and thus increasing unemployment, such an increase would hurt many of the people who it was designed to help.
Economic theory argues that a binding minimum wage will decrease the number of jobs and increase
unemployment. It also predicts that the people who find jobs at the higher rate will potentially be better off (it depends
in part on how costly it was for them to find employment). The Congressional Budget Office (CBO) is a highly
respected agency that conducts bipartisan economic analysis for Congress. In February 2014, the CBO issued a report
projecting the impact of the proposed increase in the minimum wage. Consistent with economic theory, they predicted
that the proposed hike would cause a loss of about 1�2 million jobs. They further predicted that 16.5 million workers would experience wage increases. About 900,000 of them would be lifted out of poverty.
The higher wages paid to workers will have to be paid by someone—there is no “free lunch.” As discussed in this
chapter, the ultimate payers are not necessarily the companies that are required to pay higher wages. At least some of
this cost increase is likely to be passed to consumers in the form of higher prices. Moreover, many employees currently
hired at the minimum wage are entry-level workers with limited work experience and education. The increase in the
quantity of labor supplied at the higher wage rate is likely to include suburban middle-class teenagers and others who
have some more prior work experience. Given the limited number of jobs openings relative to people seeking work at
the higher wage rate, the prospects of a minority, high-school dropout finding work could be even more bleak.
Source: E. Morath, D. Paletta, and C. Lee (2014), “Wage-Rise Report Sees Fewer Jobs, Less Poverty” The Wall Street Journal (February 20).
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96 Part 1 Basic Concepts
costs, it is likely to select an inefficient level of pollution (i.e., to overpollute). In choosing how much to invest in pollution control equipment, the firm’s managers will consider only its own costs and benefits. Efficient investment would require them also to consider costs and benefits imposed on neighbors (the efficient level of investment is where the total marginal costs of additional investment equal the total marginal benefits—not just those incurred privately by the firm).
Economists used to think that externalities surely would prevent a market system from producing an efficient allocation of resources. Government intervention seemed to be required to enhance efficiency. For example, the traditional recom- mendation was to tax firms based on their levels of pollution. Such a tax would give firms incentives to reduce pollution.
In 1960, Nobel Prize winner Ronald Coase presented a compelling argument that exchange in a free market is more powerful in producing efficient results than had been thought previously. As long as property rights can be traded, there is an incen- tive to rearrange these rights to enhance economic efficiency. The often-recom- mended government intervention might be unnecessary and in many cases undesir- able. Suppose that a firm has the legal right to pollute as much as it wants. Its neighbors always can offer to pay the firm to reduce its pollution level. Thus, the firm faces a cost for polluting (if the firm pollutes, there is an opportunity cost of not receiving compensation from its neighbors). The firm will pollute only if the pollution is more valuable to the firm than the costs it imposes on its neighbors. This efficient solution is obtained without a pollution tax. The same level of pollu- tion can occur even if the neighbors have the legal right to stop the firm from emit- ting any pollution as opposed to the firm’s having the legal right to pollute as much as it wants. In this case, the firm can pay its neighbors for the right to pollute. Re- gardless of whether the firm or the neighbors have the legal right, the gains from trade are exhausted when the marginal benefit to the firm of polluting is equal to the sum of the marginal costs imposed on its neighbors plus those that the firm bears.
Coase’s argument convinced most economists that externalities were less of a problem than previously thought. It also implied that the distribution of property (legal) rights might have less of an effect on the ultimate use of resources than it has on the distribution of income—as long as these rights can be exchanged. In our ex- ample, the firm might emit the same amount of pollution regardless of who initially is assigned the property right. However, the party with the property right obtains more wealth (since it is the one receiving or avoiding payments).
Nonetheless, as Coase points out, market exchange will not always solve the problem of externalities. The transactions that are necessary to overcome this
problem are not free: There are contracting costs. These costs in- clude search and information costs, bargaining and decision costs, and drafting, policing, and enforcement costs.16 These costs can pre- vent a preferred outcome from occurring. In our example, the firm might limit its pollution for a payment that is far lower than the col- lective damage imposed on its neighbors. Nonetheless, the costs of bargaining with the firm and the costs of reaching agreement on how the neighbors should split the payment can prevent this mutually ben- eficial agreement from being reached. Generally, the costs of reaching an agreement increase with the number of bargainers. In our example,
16C. Dahlman (1979), “The Problem of Externality,” The Journal of Law and Economics 22, 148–162.
The Coase Theorem The ultimate resource allocation will be efficient, regardless of the initial assignment of property rights, as long as contracting costs are sufficiently low and the property rights are assigned clearly, are well enforced, and can be exchanged readily.
the likelihood of reaching an efficient agreement is highest if the firm only has to bar- gain with a single neighbor who owns all the surrounding property.
It also is important that property rights be clearly assigned, enforced, and ex- changeable. Suppose there were no legal system to enforce property rights. Neigh- bors would be reluctant to pay a firm not to pollute—they do not obtain an enforce- able property right to prevent the firm from polluting. After collecting the payment, the firm could renege on its promise to reduce pollution and the neighbors would have no recourse.
This discussion suggests that market economies will tend to produce an efficient resource allocation whenever property rights are clearly assigned and contracting costs of exchanging them are sufficiently low. When these conditions are met, effi- ciency will occur regardless of the initial distribution of property rights. This general principle is often referred to as the Coase Theorem.
The driving force behind the Coase Theorem is gains from trade: Individuals have incentives to search out and undertake mutually advantageous trades. This principle has important managerial implications. Even if a manager does not have all the prop- erty rights necessary to undertake a particular project, it does not mean that the pro- ject cannot be undertaken. If the proposed project creates enough value, the manager often can acquire the necessary property rights from their current owners. Suppose the Watts Construction Company can create substantial value by developing a shop- ping center on a site that currently is zoned for residential housing. Surrounding property owners might support a change in the zoning requirement, as long as they share in the value creation. Watts might be able to increase this support by offering to develop a new neighborhood park near the shopping mall.
Chapter 3 Exchange and Markets 97
M A N A G E R I A L A P P L I C AT I O N S
Property Rights Help Make Niger Greener Niger in northern Africa historically has been known for being a barren, dust-choked country with many starving
citizens. Most observers saw no hope in Niger’s continued battle against desertification. The end result would be
increased poverty and starvation.
Recent studies of vegetation patterns, however, show that Niger recently has added millions of new trees and is far
greener than it was 30 years ago. Interestingly some of the vegetation is densest in some of the most densely populated
regions of the country. This finding runs counter to the conventional claim that population growth leads to the loss of
trees and accelerates land degradation.
One important factor for why Niger has become greener is a change in property rights. From colonial times, all
trees in Niger were property of the state. State ownership gave farmers little incentive to grow and protect trees. Trees
were cut down by residents for construction and chopped for firewood with little regard for the environmental costs.
Government foresters were supposed to foster the growth of trees and to protect them from illegal destruction, but there
were not enough foresters for an area nearly twice the size of Texas. Now the government allows individuals to own
trees—there is private rather than public ownership. Farmers make money from their trees by selling branches, pods,
fruits, and bark. Because these sales are more lucrative over time than cutting trees for firewood, the farmers preserve
and protect them.
Niger remains in a fragile position since it is located in a drought-prone area. Recently acquired private property
rights, however, have helped to foster the growth and protection of trees. According to experts, “more trees will help
Niger’s people to withstand whatever changes the climate might bring.” Observers note that the improved situation in
Niger was accomplished without having to spend a “lot of money.”
Source: L. Polgreen (2007), “In Niger, Trees and Crops Turn Back the Desert,” nytimes.com (February 11).
98 Part 1 Basic Concepts
The Coase Theorem also suggests that contracting costs are central to the study of organizations. In the absence of contracting costs, efficient outcomes will occur in- dependent of the way decision rights are assigned. From an efficiency standpoint, it does not matter whether decision rights are centralized or decentralized. It is con- tracting costs that make these organizational considerations important. We elaborate on this issue in the section that follows.
Markets versus Central Planning History suggests that the price system is more efficient at controlling and coordinat- ing production and consumption decisions in large economies than is central plan- ning. Without the aid of government planners, market economies have produced products that are highly valued by consumers while avoiding large shortages or sur- pluses. In planned economies such as the former Soviet Union, shortages, surpluses, and other production mistakes are common.
There are at least two reasons why markets have been more successful than central planning in large economies. First, the price system motivates better use of knowledge and information in economic decisions. Second, it provides stronger incentives for in- dividuals to make productive decisions. As we will discuss later, an understanding of these advantages can be useful for managers in making firm-level decisions, such as what decision-making authority to delegate to employees and whether to make or buy a firm’s inputs.
General versus Specific Knowledge17
Figure 3.14 shows how the costs of transferring knowledge can be displayed on a continuum. At one end of this continuum is general knowledge. General knowledge is virtually free to transfer. Examples of general knowledge are prices and quanti- ties—a storekeeper easily can tell you that the price of sugar is $1 per pound. As the costs of information transfer increase, the information is said to become more specific. We use the term specific knowledge to denote knowledge that is relatively high on this scale: It is expensive to transfer.
Information transfer costs
General knowledge Specific knowledge
Figure 3.14 The Cost of Transferring Knowledge
The costs of transferring knowledge can be displayed on a continuum. At one end is general knowledge, which essentially is free to transfer. As the costs of information transfer increase, the information is said to become more specific. We use the term specific knowledge to denote knowledge that is relatively expensive to transfer.
17This section draws on M. Jensen and W. Meckling (1995), “Specific and General Knowledge, and
Organizational Structure,” Journal of Applied Corporate Finance 8:2, 4–18.
At least three factors influence the costs of transferring information. First are the characteristics of the sender and receiver. Generally, it is less expensive for people of similar training, language, and culture to communicate than for people from differ- ent backgrounds. Second is the technology available for communication. For exam- ple, the development of electronic mail (e-mail) has lowered the costs of transferring information. Third is the nature of the knowledge itself. Some knowledge is difficult to summarize, comprehend, or transfer in a timely fashion. Depending on the exact setting, the following types of knowledge often are specific in nature:
• Idiosyncratic knowledge of particular circumstances. The employee on the spot is most likely to know if a particular truck has room for additional cargo or if a certain customer wants to purchase a specific product. If this information is not used immediately, it may become useless. For example, by the time the in- formation about the truck is transferred to another person (such as a central scheduler), the opportunity to load the truck with additional cargo can be lost (for instance, if the truck has departed).
• Scientific knowledge. Knowledge of how recombinant DNA works is not eas- ily transferred to nonscientists.
• Assembled knowledge. An accountant who has completed a client’s tax re- turns for several years is likely to have assembled important knowledge about the relevant parts of the tax code and the idiosyncrasies of the individual’s
M A N A G E R I A L A P P L I C AT I O N S
The Dynamic Nature of Specific Knowledge Historically, economies of scale have motivated firms in retailing to concentrate on standardized production and
distribution. Knowledge about the idiosyncratic demands of people in particular neighborhoods tended to be ignored in
stocking individual stores within a large retail chain: The information simply was too expensive to collect and process.
This limited their ability to compete with small local stores that catered to the specific demands of local customers.
But the development of computers and electronic scanners has made information about idiosyncratic demands of
individuals less specific. As a result, retail companies have begun to engage in more micromarketing. For instance, the
Sears outlet in the North Hollywood section of Los Angeles is tailor-made to suit the neighborhood’s Hispanic
population. Signs are in Spanish. The store is stocked with ethnic items, such as a broad selection of compact discs and
tapes by Latin American artists. A few hundred miles to the north, the Sears store in San Jose offers a large number of
clothing items in extra-small sizes to attract the area’s Asian population. On the other hand, Sears stores in Florida
carry large, roomy clothes that appeal to the large population of elderly residents.
Source: (1995) “Customers on Target,” Financial Times (August 18).
Chapter 3 Exchange and Markets 99
M A N A G E R I A L A P P L I C AT I O N S
Topic-Specific Search Engines GlobalSpec.com is competing with Yahoo and Google—and winning. Its search engine for engineers has 3.5 million
users and adds 20,000 more each week. “They own that market,” says Charlene Li of Forrester. GlobalSpec has a well-
defined customer base and detailed understanding of its users; this sets it apart from the generalist search engines.
These features allow its “vertical site” to provide search results from a select group of topic-specific Web sites and
precisely target advertising at particular audiences.
Source: (2007) “Specific Knowledge about Your Customer,” The Economist (July 14), 75.
100 Part 1 Basic Concepts
income and deductions. Another example is learning to operate a complex ma- chine. In neither case is this information easily transferred to others.
Specific knowledge is critical in properly allocating resources. Many economic opportunities are short-lived and must be acted on quickly by the person on the spot (who has the specific information of the opportunity) or lost. Not incorporating the proper scientific or assembled knowledge into economic decisions can have costly implications. For an economic system to be successful, it must promote the use of relevant specific knowledge in economic decisions.
Knowledge Creation
It is important to realize that knowledge is dynamic. There are at least two factors that can motivate changes in the costs of transferring knowledge. The first is tech- nology: Improved communications and computer technology have greatly lowered the costs of transferring certain types of information, making it more general. Sec- ond, individuals can take actions to convert specific knowledge to more general knowledge, for example, by drafting an operating manual.
Nonaka and Takeuchi argue that converting hunches, perceptions, mental mod- els, beliefs, experiences, and other types of specific knowledge into a form that can be communicated and transmitted in formal and systematic language is a key aspect of successful new product innovation.18 As one example, consider Matsushita’s development of an automated fresh bread maker in the 1980s. Specific knowledge of how to knead dough to produce tasty bread was held by master bakers. This knowledge was not easily transferred to others, and past attempts to produce fully automated bread makers had failed because they produced poor-quality bread. Yet specific knowledge about how to manufacture automated bread machines was held by engineers. To produce a successful bread machine, relevant specific knowledge had to be transferred between bakers and engineers. To accomplish this transfer, managers from Matsushita took bread-making lessons from a master baker at an Osaka hotel. Eventually, the managers discovered that the key to good bread mak- ing is to twist and stretch the dough during the kneading process. This concept was general knowledge that could be passed along to design engineers. Matsushita’s “Home Baker” was the first fully automatic bread-making machine for home use and has become a quite successful product.
In 1778, economist–clergyman Thomas Malthus predicted that population would grow more rapidly than the food supply resulting in mass starvation.19 His argument was straightforward: Because land and other natural resources are finite, the growth in population (fueled by the “passion of the sexes”) would eventually exceed the available food supply. But this prediction—which prompted economics to be labeled the “dismal science”—has not come to pass. For instance, population in the United States increased from 76 million in 1900 to 296 million in 2005 (an increase of nearly 300 percent), yet the amount of land and the number of workers devoted to
18I. Nonaka and H. Takeuchi (1995), The Knowledge-Creating Company (Oxford University Press: New York).
19T. Malthus (1778), “An Essay on the Principle of Population” (printed for J. Johnson, in St. Paul’s Church
Yard, London).
Chapter 3 Exchange and Markets 101
agricultural production over the same period fell dramatically. Today less than 3 per- cent of the U.S. population works in agriculture, while the per capita food supply is at an all-time high. And this increase in the food supply is not just a U.S. phenomenon. From 1951 to 1992, world food production per capita increased 34 percent.20 So why was Malthus wrong?
Malthus, as well as more recent pessimists, has underestimated the importance of improvements in technology—figuring out better ways to use existing re- sources.21 For example, today’s computers are far more powerful than those of a decade ago, yet they take fewer resources to produce. Moreover, computer de- signers have discovered ways to make the materials used in computers more re- cyclable. This process of discovering better ways to use existing resources occurs not only in manufacturing but also in service-related industries as well. For ex- ample, consider the implications of McDonald’s innovations in the 1950s in the delivery of “fast food.”
Economist Paul Romer argues that the opportunities for this type of discovery and growth essentially are unlimited.22 People are constantly taking ideas and knowledge that are in their “wetware” (brains) and converting them into “software” (recipes and formulas) that can be employed to produce new products and services. Matsushita’s conversion of the specific knowledge held by the master baker into more general knowledge that could be used by engineers is a good example. As we will discuss in Chapter 8, good managers understand this mechanism for creating knowledge and value and foster it within their firms.
20J. Perloff (2001), Microeconomics (Addison Wesley: Boston), 154. 21For a more recent example of concern about the implications of finite resources, see D. Meadows New York
(1977), Limits to Growth: A Report for the Club of Rome’s Project on the Predicament of Mankind (New York American Library).
22For nontechnical discussions of Romer’s theory of economic growth, see P. Romer (1993), “Economic
Growth,” Fortune Encyclopedia of Economics (Time Warner Books: New York); P. Romer (1995), “Beyond the Knowledge Worker,” World Link, (January/February), 55–60.
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Converting IT Wetware into Software Charles Belford, president of the Canadian-based management consulting firm Managements Smarts, Inc., advises
clients to get more value out of their existing information technology (IT) without buying new software or hardware.
He argues that firms should revise their current delegation of authority, governance, and planning and management
practices to identify low-cost, low-risk IT enhancements. Managers should be given incentives to ensure that successful
pilot tests are properly identified and then disseminated throughout the organization. He encourages clients to
reorganize so that a senior manager has enterprise-wide oversight to exploit IT packages to ensure their full potential
for the company. For an example, Mr. Belford says, “By revising the current delegation of authority for managing Web
site content in your company, you may be able to turn your obese Web site or your bulimic internal intranet network
into healthy assets that actually serve their respective constituencies.”
Mr. Belford maintains that the only way to convert IT wetware (successful local IT applications) into recipes or
software and then leverage this newly created software throughout the firm is by changing the company’s
organizational architecture.
Source: C. Belford, “Add Value to Tech Assets without Breaking the Bank,” The Globe and Mail (March 28, 2002), B16.
102 Part 1 Basic Concepts
Specific Knowledge and the Economic System23
Nobel Prize–winner Friedrich Hayek offered a compelling argument that market economies are more likely than centrally planned economies to incorporate relevant specific knowledge in economic decision making. He argued that the relevant spe- cific knowledge for economic decision making is not given to any one individual; in- stead, it is distributed among many people in the economy. This knowledge, by def- inition, does not lend itself to statistical aggregation; it is costly to transfer. A central planner invariably lacks the mental or computing ability to process large volumes of this sort of information. Hayek thus concluded that central planners often ignore im- portant specific knowledge in economic decisions.
In contrast, economic decisions in a market system are decentralized to individu- als who are likely to have the relevant specific knowledge. Technical and marketing geniuses, like William Gates at Microsoft and Michael Dell at Dell Computer, are free to start new businesses and to market products of their choosing. The information that motivates these decisions does not have to be transferred to some central office in Washington where centralized production decisions are made. Thus, the information is more likely to be used effectively.
The activities of decentralized decision makers are coordinated by prices. For in- stance, an increase in market-determined wage rates (the price of labor) signals to pro- ducers that labor is in short supply and should be conserved. Higher wages, in turn, motivate producers to conserve labor. An important advantage of the price system that is stressed by Hayek is that prices economize on the costs of transferring information to coordinate decisions. Companies normally do not have to know all the details of why labor costs have increased. The simple fact that wages have increased tells them most of the things they need to know to make value-maximizing decisions.24
Incentives in Markets
Private property rights are critical for making a market economy work because they provide strong incentives for decentralized decision makers to act on their specific information—the wealth effects of economic decisions are borne directly by the re- source owners. If Alice Chan owns a piece of property, she has incentives to use the land productively because she gets to keep any profits. If Jamal Hammoud can make more productive use of the land, Alice will sell the land to Jamal (there are gains from trade). Property rights are rearranged so that decision rights over re- sources are linked with the relevant specific knowledge.
In contrast, decision makers in centrally planned economies have limited incentives to make productive use of information (even if they have it) since they do not own the resources under their control. Further, lower-level bureaucrats have lim- ited incentives to carry out decisions made by the central authority. The best use of a particular automobile might be to transport tourists from a local airport. A central planner, however, might give the car to his brother because he is more concerned about making his brother happy than about making the economy more productive. After all, he does not keep the profits from transporting tourists—they go to the state.
23This section draws on F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.
24Producers also might want to know the expected future prices of labor. For instance, if the price increase is
expected to be transitory, the company might want to avoid making layoffs.
Contracting Costs and Existence of Firms Hayek’s argument suggests that markets are better than central planning. Why, then, is so much activity conducted within firms, where resource allocation decisions are made by managers in a manner that is closely akin to central planning?25
Conceptually, firms do not have to exist. All production and exchange could be car- ried out through market transactions. In the case of the PC, each consumer could buy all the parts that make up the PC in separate market transactions and then pay some- one to assemble them. In reality, of course, most computers are made by firms and only the final products are sold to the consumer.
Ronald Coase provides an answer to the question as to why resources are allocated by both markets and firms.26 His basic argument is that economic transac- tions involve contracting costs, including search and information costs, bargaining and decision costs, and policing and enforcement costs. There is also an opportunity
ANALYZING MANAGERIAL DECISIONS: Nobel Prize–Winner F. A. Hayek on the “Miracle” of the Price System
It is worth contemplating for a moment a very sim-
ple and commonplace instance of the action of the
price system to see what precisely it accomplishes.
Assume that somewhere in the world a new oppor-
tunity for the use of some raw material, say, tin, has
arisen, or that one of the sources of supply of tin
has been eliminated. It does not matter for our pur-
pose—and it is significant that it does not matter—
which of these two causes has made tin more
scarce. All that the users of tin need to know is that
some of the tin they used to consume is now more
profitably employed elsewhere and that, in conse-
quence, they must economize tin. There is no need
for the great majority of them even to know where
the more urgent need has arisen, or in favor of what
other needs they ought to husband the supply. If
only some of them know directly of the new de-
mand and switch resources over to it, and if the
people who are aware of the new gap thus created
in turn fill it from still other sources, the effect will
rapidly spread throughout the entire economic sys-
tem. This influences not only all the uses of tin but
also those of its substitutes and the substitutes of
these substitutes, the supply of all things made of
tin, and their substitutes, and so on. All this takes
place without the great majority of those instru-
mental in bringing about these substitutions know-
ing anything at all about the original cause of these
changes. The whole acts as one market, not be-
cause any of its members surveys the whole field,
but because their limited individual fields of vision
sufficiently overlap so that through many interme-
diaries the relevant information is communicated to
all. The mere fact that there is one price for any
commodity—or rather that local prices are con-
nected in a manner determined by the cost of trans-
port, etc.—brings about the solution which (if con-
ceptually possible) might have been arrived at by
one single mind possessing all the information
which is in fact dispersed among all the people in-
volved in the process.
Some people (e.g., Hayek) argue that decentral-
ization of economic decisions in the economy leads
to an efficient resource allocation. What differences
exist within the firm that make the link between de-
centralization and efficiency less clear?
Source: F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.
25Within a firm, resources often are transferred from one division to another by an administrative order from
management. For example, managers often are transferred among divisions by administrative decisions.
Prices are not used to make these decisions—the divisions typically do not bid for the managers. 26R. Coase (1937), Economica, “The Nature of the Firm,” New Series, IV, 386–405.
Chapter 3 Exchange and Markets 103
104 Part 1 Basic Concepts
cost if the transaction results in an inefficient resource allocation (we discuss this in detail in Chapter 10). The optimal method of organizing a given economic transac- tion is the one that minimizes contracting costs.27 In some cases, the method will be market exchange. In other cases, the method will involve firms.
Contracting Costs in Markets
A primary set of costs of using markets for exchange involves the discovery and ne- gotiation of prices.28 For example, firms have the following two potential advan- tages:
• Fewer transactions. If there are N customers and M factors of production, a firm can hire the M factors and sell to the N customers. The total transactions are N � M. In contrast, if each customer contracts separately with each factor of production, there are N � M transactions. For example, 10 workers might be required to assemble a computer. If there are 1,000 customers and each cus- tomer negotiates with each worker, there are a total of 10,000 transactions. If a firm hires the 10 workers and sells computers to the 1,000 customers, there are 1,010 transactions.
• Informational specialization. Think of buying a PC. How much do you know about buying each separate part? PC producers, on the other hand, specialize in this knowledge. The consumer buying from a firm only has to be concerned with the quality of the end product.
In Chapter 19, we shall elaborate on one particularly important set of contract- ing costs that motivates the existence of firms, those associated with specific assets. Assets are specific when they are worth more in their current use than in alternative uses. An extreme example is a machine that is used to produce parts that can be used only by one particular producer. The machine is valuable in producing parts for the particular buyer but is essentially worthless in alternative uses. In this case, independent suppliers are reluctant to purchase the machine since they do not want to be at the mercy of a single buyer. For instance, suppliers might worry that the buyer will try to force a reduction in future prices, make unreasonable quality or quantity demands, or curtail purchases. It is these concerns that make simple mar- ket transactions between buyers and sellers unlikely when the relevant assets are highly specific. A potential response to this problem is for the producer to own the machine and make the input parts within a single larger firm.
Another potential advantage of firms is that in some cases they can reduce contracting costs through established reputations. Individuals are likely to have con- fidence in trading with parties who are expected to continue to participate in the marketplace over a long time. They understand that these parties have incentives to be honorable in order to enhance their reputation and future business opportunities.
27It is not always possible to separate contracting costs from the basic costs of production. The optimal method
of production can depend on the way the transaction is organized. Therefore, it is more precise to say that
the optimal method of organization is the one that minimizes total costs (production and contracting costs).
The basic arguments are easier to explain if we focus on contracting costs. 28Economists generally agree that contracting costs motivate the existence of firms. There is disagreement
concerning which contracting costs are most important. Our intent in this chapter is to give the reader a
general sampling of the kinds of costs that can be important.
Organizations tend to have longer lives than individuals and thus might be expected to be more likely to honor agreements than unknown individuals (some major cor- porations date back to the nineteenth century). This increased trust can motivate lower expenditures on negotiating and policing agreements.
Government regulation also helps explain the existence of some firms. Sometimes firms can produce more cheaply because they avoid taxes at intermediate stages of production compared to market transactions.
Contracting Costs within Firms
We have discussed several contracting costs that can motivate the existence of firms. Given these costs, why isn’t the economy just one big firm? The answer is that re- source allocation by firms also involves contracting costs. For example, as firms be- come larger, it becomes increasingly difficult for managers to make efficient and timely decisions. They are more likely to make errors and to be less responsive to changing circumstances. As a firm grows, important decisions must be delegated to employees who are not owners of the firm, thereby generating costs to motivate these nonowners to work in the interests of the owners.
Herbert Simon on Organizations and Markets The United States often is referred to as a market economy. In reality, much of the economic activity in the United
States, as well as in other market economies, is conducted within firms. To quote Herbert Simon, a former Nobel Prize
winner,
Suppose a visitor from Mars approaches the earth from space, equipped with a telescope that reveals social structures. The firms reveal themselves, say, as solid green areas with faint interior contours marking out divisions and departments. Market contracting costs show as red lines connecting firms, forming a network in the spaces between them. Within the firms the approaching visitor also sees pale blue lines, the lines of authority connecting bosses with various levels of workers. . . . No matter whether the visitor approached the United States or the Soviet Union, urban China or the European Community, the greater part of the space below would be within the green areas, for almost all the inhabitants would be employees, within firm boundaries. Organizations would be the dominant feature on the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lines.” It would not likely speak of a “network of red lines connecting green spots.”
Source: H. Simon (1991), “Organizations and Markets,” Journal of Economic Perspectives 5, 25–44.
A C A D E M I C A P P L I C AT I O N S
Chapter 3 Exchange and Markets 105
Corporate Focus and Stock Returns Ronald Coase argues that the use of markets involves contracting costs and that sometimes these costs can be reduced
by including transactions within firms. However, firms also involve contracting costs. In the 1990s, many companies
concluded that they had become too large and diversified. These companies, in turn, decided to refocus on their core
businesses and to shed unrelated activities (e.g., through asset sales). Evidence suggests that on average, these firms
increased their stock market values by increasing their focus on core activities.
Source: R. Comment and G. Jarrell (1995), “Corporate Focus and Stock Returns,” Journal of Financial Economics 37, 67–87.
A C A D E M I C A P P L I C AT I O N S
106 Part 1 Basic Concepts
Efficient Organization Individuals involved in trade and production have incentives to implement cost-re- ducing methods of organization because there are greater gains to be shared. For ex- ample, at a given price, more profits can be generated if costs are reduced.29 In com- petitive markets, individuals will constantly search for new and better ways to reduce costs to improve their competitive advantage and profits. The bottom line is that firms will be used to organize economic activities whenever their cost is lower than that of using markets, and vice versa. Also, as we will see, this same process has im- portant implications for the internal design of organizations.
Managerial Objectives Our discussion to this point has treated decision makers within firms as owners. Owners have a strong interest in increasing the profits of the firm, since they get to keep the proceeds. In public corporations managers are rarely major owners of the firm. Nonetheless, in Chapters 4 to 9 the book, we assume that managers strive to maximize firm profits—or more precisely firm value, the present value of the firm’s profit stream: They make input, output, and pricing decisions with value maximization as their sole objective.30 This perspective is a reasonable starting point because if firms fail to make profits over time, they cease to exist. Most managers are under constant pressure to create value. There also are other mechanisms, such as incentive compensation, that can be structured to align the interests of managers and owners. These mechanisms help make profit maxi- mization a reasonable first approximation of the managers’ objective function. Profit maximization is the basic premise used in most economics textbooks. Start- ing in Chapter 10, however, we shall present a richer characterization of the firm and analyze management/owner conflicts in greater detail. The appendix to this chapter provides a more detailed discussion of managerial objectives, focusing on the topics of shareholder value and stock-market efficiency.
Managerial Decisions We began this chapter with an overview of how market economies operate. An under- standing of this topic is critical if managers are to make productive economic decisions. It is important to understand how a shift in either supply or demand affects
29A firm’s profit (II) is the difference between its total revenues (TR) and total costs (TC): II � TR � TC. If
a company has sales of $1 million and costs of $750,000, it earns a profit of $250,000. 30Much of our basic analysis focuses on maximizing profit in a single period. This approach yields useful
managerial insights without overly complicating the analysis.
CEO Turnover and Firm Profits A standard assumption in microeconomics is that managers strive to maximize profits. One reason that managers are
likely to be concerned about profits is that poor profits and stock price performance increase the likelihood that they
will be fired. For instance, research suggests that the worst performing firms are about 1.5 times as likely to have a
management change as the best performers.
Source: For a review of this evidence, see J. Brickley (2003), “Empirical Research on CEO Turnover and Firm Performance: A Dis-
cussion,” Journal of Accounting and Economics 36, 227–233.
A C A D E M I C A P P L I C AT I O N S
product prices. (In Chapters 4 to 9, we shall extend this analysis and examine in more detail how managers might make optimal input, output, and pricing decisions.)
We also discussed the role of knowledge and incentives in determining the ef- fectiveness of alternative economic systems and the importance of contracting costs in determining whether or not economic transactions are conducted within
Firms versus Markets: When Markets Ruled Economic theory argues that activities are organized within firms when the cost is lower than using markets, and vice
versa. Today, much of the economic activity in the world is conducted within firms. It is hard to envision a world where
large firms do not play an important role in the production and distribution of products. The importance of firms,
however, is a relatively recent phenomenon. Prior to the middle of the nineteenth century, there were virtually no large
firms. Most production was conducted by small, owner-managed operations. The activities of these operations were
coordinated almost entirely through market transactions and prices. To quote Alfred Chandler in describing business
organization before 1850,
The traditional American business was a single-unit business enterprise. In such an enterprise an individual or a small number of owners operated a shop, factory, bank, or transportation line out of a single office. Normally this type of firm handled only a single economic function, dealt in a single product line, and operated in one geographic area. Before the rise of the modern firm, the activities of one of these small, personally owned and managed enterprises were coordinated and monitored by market and price mechanisms.
The large firm became feasible only with the development of improved energy sources, transportation, communications,
and legal/court systems. Coal-fired steam power generators provided a source of energy that made it possible for the
factory to replace artisans and small mill owners, and railroads enabled firms to ship production in large quantities to
newly emerging urban centers. The telegraph allowed firms to coordinate activities of workers over larger geographic
areas. These developments tended to make it less expensive to coordinate production and distribution using
administrative controls, rather than to rely on numerous market transactions among all the intermediaries in the system.
Source: A. Chandler (1977), The Visible Hand: The Managerial Revolution in American Business (Harvard University Press: Cambridge, MA).
A C A D E M I C A P P L I C AT I O N S
ANALYZING MANAGERIAL DECISIONS: Labor Unions and a Proposed Tax on Luxury Goods
You work as a stock analyst. You specialize in ana-
lyzing markets for “high-end” manufactured prod-
ucts. The President has recommended that Con-
gress impose a tax of $20,000 on every person who
purchases a new yacht. He argues that rich people
who can afford to purchase yachts (they cost
around $2,000,000 each) should pay higher taxes.
The money raised would be used to provide addi-
tional benefits to returning war veterans.
You are writing a research report on the firms
that manufacture yachts. You want to include a
statement in the report about whether you think the
proposal is likely to pass Congress and become
law. You have analyzed the proposal and the voting
records of members of Congress. You have decided
that the proposal will not obtain enough votes to
pass Congress, unless the major labor unions rep-
resenting employees in this industry support it. You
know that many of the yacht-producing firms hire
veterans who could benefit from the programs
funded by the tax.
a. Draw a standard supply and demand diagram depicting the market for yachts prior to the tax.
b. Analyze the effects of imposing a $25,000 per yacht tax on consumers (on a qualitative basis).
c. Based on this analysis, do you think that the labor unions will support the proposed tax?
Explain. What does it depend upon?
Chapter 3 Exchange and Markets 107
108 Part 1 Basic Concepts
markets or organizations. Although we have focused our discussion at the economic-system level, these issues are directly relevant to understanding firm- level decisions on organizational architecture. If firms are to be productive, they must be structured in ways that promote the use of the relevant specific knowledge and economize on the costs of organization. They also must establish appropriate incentives, so that their employees act in a productive manner. Starting in Chapter 10, we shall extend the concepts introduced in this chapter to questions of organi- zational architecture.
Summary There are many different ways of organizing economic activities. Economists focus on Pareto efficiency in evaluating the effectiveness of alternative economic systems. An allocation is Pareto-efficient if there is no alternative that keeps all individuals at least as well off but makes at least one person better off. Pareto-improving changes in a resource allocation are viewed as welfare-increasing.
An important feature of a market economy is the use of private property rights. A property right is a legally enforced right to select the uses of an economic good. A property right is private when it is assigned to a specific person. Private property rights are alienable in that they can be transferred (sold or gifted) to other individuals.
In free markets, property rights frequently are exchanged. Trade occurs because it is mutually advantageous. The buyer values the good more than the seller, and there are gains from trade. Trade is an important form of value creation. Trading produces value that makes individuals better off. Gains from trade also motivate the movement of resources to more productive users. Total output and standards of living often in- crease when individuals specialize in production activities for which they have a comparative advantage (lower opportunity costs).
Prices coordinate the individual actions in a market economy. If too little of a good is being produced, inventories will shrink, prices will rise, and producers will have incentives to increase output to exploit the profit opportunity. If too much of a good is being produced, prices will fall, inventories will build, and producers will have incentives to cut production. The market is in equilibrium when the quantity supplied of a product equals the quantity demanded. There are strong pressures in competitive economies that move the market toward equilibrium. In equilibrium, there are no shortages or surpluses and inventories are stable at their desired levels. Equilibrium prices and quantities change with changes in the supply and demand for products.
Consumer surplus and producer surplus are measures of the gains from trade to consumers and producers from participating in a market. Government-imposed price caps or floors result in market imbalances and lost surplus (in an otherwise well- functioning market).
Externalities exist when the actions of one party affect the consumption or pro- duction possibilities of another party outside an exchange relationship. Externalities can cause markets to fail to produce an efficient resource allocation. Competitive markets will produce a Pareto-efficient allocation of resources if the costs of making mutually advantageous trades are sufficiently low. The Coase Theorem indicates that the ultimate resource allocation will be efficient, regardless of the initial assignment of property rights, as long as contracting costs are sufficiently low and property rights are clearly assigned, well enforced, and readily exchangeable.
General knowledge is inexpensive to transfer, whereas specific knowledge is ex- pensive to transfer. Specific knowledge is quite important in economic decisions.
Chapter 3 Exchange and Markets 109
Central planning often fails because important specific knowledge is not incorpo- rated in the planning process. Within market systems, economic decisions are decentralized to individuals with the relevant specific knowledge. Prices convey gen- eral knowledge that coordinates the decisions of individuals. Private property rights provide important incentives to individuals to act productively, since they bear the wealth effects of their decisions.
In principle, all economic activity could be conducted through market transac- tions. However, even in market economies, much economic activity occurs within firms, where administrative decisions rather than market prices are used to allocate resources. Firms exist because of the contracting costs of using markets. However, organizing transactions within firms also involves costs. Individuals have incentives to organize transactions in the most efficient manner—to increase the gains from trade. Economic activities tend to be organized within firms when the cost is lower than that of using markets, and vice versa.
This chapter provides important background information on both markets and organizations. In Chapters 4 to 9, we shall extend the analysis of markets and study important managerial decisions such as output, inputs, pricing, and strategy. In these next six chapters, we assume that managers strive to maximize firm profits. In the remainder of the book, we shall extend the analysis of organizations and cover a variety of important topics about organizational design. A reader interested primarily in organizational design can move directly to Chapter 10 without loss of continuity.
R. Coase (1988), The Firm, the Market, and the Law (The University of Chicago Press: Chicago).
J. Earwell, M. Milgate, and P. Newman (1989a), Allocation, Information, and Markets (W.W. Norton: New York).
——— (1989b), The Invisible Hand (W.W. Norton: New York).
F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.
M. Jensen and W. Meckling (1995), “Specific and General Knowledge, and Organizational Struc-
ture,” Journal of Applied Corporate Finance 8:2, 4–18.
O. Williamson (1985), The Economic Institutions of Capitalism (Free Press: New York).
3–1. Two men, Tom Hanks and Forest Gump, have been marooned separately on the same de- serted island. There are two activities each man can undertake to obtain food: fishing and
gathering coconuts. Tom can catch 40 fish per hour or gather 10 coconuts per hour. Forest
can catch 10 fish per hour or gather 8 coconuts per hour. Answer the following questions:
a. Does Tom have a comparative advantage in producing both products? Explain. b. Tom and Forest have not yet met. Tom is working 2 hours a day and producing (and
consuming) 48 fish and 8 coconuts (Note: the fish are very small). Forest is also work- ing 2 hours a day, but he is producing and consuming 15 fish and 4 coconuts. Now
assume that Tom and Forest meet and develop a trading relationship. Come up with a
production and trading scheme such that they can each work the same amount per day
as before, but each is better off than before. Provide specific numbers to show how
they are better off.
3–2. a. Suppose sugar has the demand curve P � 50 � 5Q and the supply curve P � 5Q. Compute the equilibrium price and quantity and show graphically. Calculate the con-
sumer surplus and producer surplus associated with this outcome.
b. What factors might cause the equilibrium price and quantity of sugar to change?
Self-Evaluation Problems
Suggested Readings
110 Part 1 Basic Concepts
Solutions to Self-Evaluation Problems 3–1. a. No, while Tom has an absolute advantage in producing both products, he only has a
comparative advantage in fishing. Forest has a comparative advantage in gathering co-
conuts. His marginal cost for gathering one coconut is 1.25 fish (10�8), while Tom has a marginal cost of 4 fish (40�10).
b. One specific example is as follows: Say Tom produces only fish and Forest produces only coconuts. There will be a total of 80 fish and 16 coconuts. Now suppose they
set a price of 2 fish per coconut and Tom buys 10 coconuts (for a price equal to
20 fish). Then Tom consumes 60 fish and 10 coconuts and Forest consumes 20 fish
and 6 coconuts. They each consume more of both commodities, so they are each bet-
ter off even though they are working the same amount as before. Many other exam-
ples could be constructed.
3–2. a. Set demand equal to supply: 50 � 5Q � 5Q and solve for the equilibrium quantity, Q* � 5. Place Q* into either the supply or demand equation and solve for the equilib- rium price, P * � $25. Graphically, the picture is
Triangle C pictures the consumer surplus. The area of a triangle is .5(Base � Height). Therefore the consumer surplus is .5(5 � 25) � $62.5. The producer surplus pictured by Triangle P is also $62.5.
b. Changes in the equilibrium price and quantity are induced by shifts in either the supply or demand curves. Factors that affect demand include such things as consumer income
and the prices of other goods. For example, if an increase in consumer income caused
the demand curve for sugar to shift to the right (an increase in demand) both the equilib-
rium price and quantity would increase. Factors that affect supply of sugar include such
things as the prices of inputs used in the production process (e.g., land, labor, and fuel
prices). If an increase in the price of labor caused the supply curve to shift to the left
(a decrease in supply), the equilibrium price of sugar would increase and the equilibrium
quantity would decrease.
3–1. What is Pareto efficiency? Why do economists use this criterion for comparing alternative economic systems?
3–2. What is a property right? What role do property rights play in a market economy?
3–3. Twin brothers, Tom and Bill, constantly fight over toys. For instance, Tom will argue it is his turn to play with a toy, while Bill argues it is his turn. Their parents frequently have to inter-
vene in these disputes. Their mom has conceived an idea that might reduce these conflicts. In
particular, every toy in the house would be “owned” by one of the boys. The owner would
have complete authority over the use of the toy. The mom reasons that ownership would cut
Review Questions
5 Q
P
$25
$50 Supply
Demand
C
P
Chapter 3 Exchange and Markets 111
down on disputes. Any time there is an argument over a toy, the owner gets the final and im-
mediate say. The boys’ dad is concerned that this idea will prevent the boys from learning to
“share.” He envisions that under the new system, Tom will not allow Bill to play with his
toys and Bill will not allow Tom to play with his toys. The old system forces them to figure
out a way to share the toys. Do you think that their dad’s concerns are valid? Explain.
3–4. Many economists favor free trade between nations. They argue that free trade will increase total world output and make people of trading nations better off. Discuss how this argument
relates to concepts presented in the chapter.
3–5. What do you think will happen to the price and quantity of DVD players if a. The availability of good movies to play on DVD players increases? b. Personal income increases? c. The price of inputs used to produce DVD players decreases? d. Ticket prices at local movie theaters decline substantially?
3–6. Suppose that the U.S. government caps the price of milk at $1 per gallon. Prior to the cap milk sold for $1 per gallon. Picture the effects of the price cap using a supply and demand
graph. Explain how the cap affects consumers and producers.
3–7. a. What is an externality? b. Why might externalities lead a firm to discharge too much pollution into a river? c. Congress has passed a law that limits the level of cotton dust within textile factories.
Why might a textile firm allow too much cotton dust within its workplace?
3–8. What is the difference between general and specific knowledge? How can specific knowledge motivate the use of decentralized decision making?
3–9. Evaluate the following statement:
Using free markets and the price system always results in a more efficient resource allocation than central planning. Just look at what happened in Eastern Europe.
3–10. a. What are contracting costs? b. Give a few examples of contracting costs. c. What effect does the existence of contracting costs have on market economies?
3–11. If markets are so wonderful, why do firms exist?
3–12. In certain professional sports, team owners “own” the players. Owners can sell or trade players to another team. However, players are not free to negotiate with other team own-
ers on their own behalf. The team owners initially obtain the rights to players through an
annual draft that is used to allocate new players among the teams in the league. They
also can obtain the rights to players by purchasing them from another team. Players do
not like this process and often argue that they should be free to negotiate with all teams
in the sporting league. In this case, they would be free to play for the team that offers the
most desirable contract. Owners argue that this change in rights would have a negative
effect on the distribution of talent across teams. In particular, they argue that all the good
players would end up on rich, media-center teams such as New York or Los Angeles
(because these teams could afford to pay higher salaries). The inequity of players across
teams would make the sport less interesting to fans and thus destroy the league. Do you
think the owners’ argument is correct? Explain.
3–13. The guide at the Washington Monument tells your 10-year-old nephew, “Enjoy the monument. As a citizen, you are one of its owners.” Your nephew asks you if that is true. What do you say?
3–14. Locust Hill Golf Club is a private country club. It charges an initiation fee of $23,000. When members quit the club, they receive no refund on their initiation fees. They simply lose their
membership. Salt Lake Country Club is also a private golf course. At this club, members join
by buying a membership certificate from a member who is leaving the club. The price of the
membership is determined by supply and demand. Suppose that both clubs are considering
installing a watering system. In each case, the watering system is expected to enhance the
quality of the golf course significantly. To finance these systems, members would pay a spe-
cial assessment of $2,000 per year for the next three years. The proposals will be voted on by
112 Part 1 Basic Concepts
the memberships. Do you think that the membership is more likely to vote in favor of the pro-
posal at Locust Hill or for the one at Salt Lake Country Club? Explain.
3–15. Critically evaluate the advice of the Providence Consulting Group, which recommended to your company,
That you analyze all the business divisions in your company. Rank them on growth po- tential. Sell all the low-growth units and invest the money in the high-growth units. Make sure not to sell the high-growth units.
3–16. Suppose that the U.S. government begins charging a $1 sales tax to all consumers for each dress shirt they buy.
a. What is likely to happen to the price (not including the tax) and quantity demanded of dress shirts? Show using supply and demand graphs.
b. What is likely to happen to the demand for sport shirts (not taxed) and undershirts (which are worn primarily with dress shirts)? Explain.
3–17. Title-loan firms offer high-interest loans (the interest rate can exceed 200 percent per year) to high-risk customers. The title of a car often is used as collateral. If the borrower defaults
on the loan, the company can repossess the car. Recently, the financial press has reported
stories of poor people who have had their cars repossessed by title lending companies. Leg-
islation is being proposed in some states to make this lending practice illegal. A proponent
of the law made the following argument. “The market for loans is very competitive given all
of the banks, savings and loans, and finance companies. Outlawing title lending will make
poor people better off. It will motivate the lending companies to provide loans with less
onerous terms. Thus, low income people and people with bad credit histories will be able to
obtain credit on more favorable terms.” Do you agree with this argument? Explain.
3–18. Suppose that annual demand in the U.S. market for ice cream cones can be expressed as QD � 800 � 0.2I � 100P, where QD is the number of cones demanded in millions of cones, I equals average monthly income in dollars, and P is price in dollars per cone. Supply can be expressed as QS � 200 � 150P (with the same units for quantity and price). a. Graph the demand and supply curves for ice cream cones, assuming that average
monthly income is $2,000, and solve for the equilibrium price and quantity.
b. Now assume that average monthly income drops to $750 and supply is unchanged. Draw the new demand curve on the same graph as used in (a) above and solve for the new equilibrium price and quantity. How would you describe the shift in demand
intuitively?
3–19. The rent control agency of Rochester has found that aggregate demand is P � 500 � 5Q D. Quantity, Q D, is measured in thousands of apartments. Price, P, equals the monthly rental rate in dollars. The city’s board of realtors acknowledges that this is a good demand esti-
mate and has shown that supply can be expressed as P � 5Q S. a. If the agency and the board are right about demand and supply, respectively, what is the
free-market price? How many apartments are rented?
b. If we assume an average of three persons per apartment, what is the expected change in city population if the agency sets a maximum average monthly rent of $100 and all
those who cannot find an apartment leave the city?
3–20. Assume that before the ice storm of 2003, the weekly demand and supply for ice in the Rochester Metro Area was given by the following equations:
Dpre: P � 100 � Q
Spre: S � 5 � 0.5Q
a. Draw a graph representing the Rochester ice market before the storm and label it care- fully. What was the equilibrium price for the Rochester ice market before the storm?
And the total quantity of ice traded?
b. As a result of the ice storm, electricity went out in the Rochester area. The demand for ice increased due to the lack of electricity to power refrigerators. The lack of power also
Chapter 3 Exchange and Markets 113
caused the supply to decrease. Ice producers were still able to produce some ice using
electric generators. Other ice had to be imported from other areas with power. The rele-
vant post-storm equations are the following:
Dpost: P � 110 � Q
Spost: P � 10 � 2Q
Draw a graph representing the Rochester ice market after the storm and label it care-
fully. What is the new equilibrium price? What is the quantity?
c. An open-ad in a local newspaper, commenting on the dramatic increase in price of ice following the storm, stated:
Obviously, avarice and greed won out over decency and morality as ice-vendors took advantage of the ice storm to increase prices and gouge their loyal customers.
Do you agree with this statement? Explain.
3–21. Suppose the supply and demand for wheat is given by:
Supply: Qs � 1,800 � 240P
Demand: Qd � 2,550 � 10I � 266P
Where P � the price per bushel of wheat and I � income. The current value of I is 100. a. Find the current equilibrium price and quantity of wheat sold in the marketplace. b. Find the equilibrium price and quantity if income increases to 150. c. Show the change in equilibrium using a standard supply and demand graph. Make sure
to label the axes and the curves. The graph does not need to be to scale. Just illustrate in
a general way what is going on.
3–22. Assume that the demand curve for sporting guns is described by Q D � 100 � 2p and the supply is described by Q S � �20 � p (Q D and Q S are in millions, p is in $). a. Compute the competitive equilibrium price and quantity. Draw a graph of a supply and
demand curve and label it correctly. Compute the total value created in the market for
sporting guns (Hint: total value � consumer surplus � producer surplus). b. Suppose that the government views sporting guns as a luxury product and taxes the con-
sumers $6 for each sporting gun they buy. Solve the new competitive equilibrium. What
losses do consumers of sporting guns incur as a result of the tax? What losses, if any, do
the producers of sporting guns incur?
3–23. Suppose there has been a storm in Nebraska that has destroyed part of the corn crop in the field. The demand curve for corn has not changed. As a result, the market clearing prices
and quantities before and after the storm are: Pb � 50, Qb � 2,000; Pa � 100, Qa � 1,500. (The subscripts a and b refer to “after the storm” and “before the storm.”) a. Assume a linear demand curve for corn; that is P � � � �Q. Calculate �, � with the
provided information, and draw the demand curve with P on the y-axis and Q on the x- axis. Label the intercept and the slope on the graph.
b. The supply curve for the period after the storm is P � (1�15)Q, and it is parallel to the supply curve before the storm. Is the supply curve before the storm above or below that
after the storm? Calculate the slope and the intercept of the supply curve before the
storm. Draw both supply curves on a new graph with P on the y-axis and Q on the x- axis. Add the demand curve (calculated in part a) to the graph.
c. Suppose consumers care only about corn consumption and apple consumption (they live in a two-good world). How would the change in the price of corn affect the budget con-
straint of the typical consumer? Show graphically. How would the change in relative
prices affect the typical consumer’s consumption of corn versus apples? Is this result
consistent with your observation from the demand and supply framework (i.e., an in-
crease in the price of corn is associated with a decrease in the equilibrium quantity)?
Explain.
114 Part 1 Basic Concepts
3-24. Suppose that the demand function for wheat is QD � 1.1 � .25P � .1I, where P � the price of wheat and I � per capita income. The supply function for wheat is QS � 4.3 � .5P � .04Po, where Po � the price of oil. Currently, I � 20 and Po � 50. a. Plot the supply curve and demand curve on the standard supply and demand graph. b. Find the equilibrium price and quantity and depict it on your graph. c. Calculate the resulting consumer surplus and producer surplus. d. What would happen to the equilibrium price and quantity if income were to increase
(holding other factors constant)? Give a brief economic explanation for why this would
occur.
e. What would happen to the equilibrium price and quantity if the price of oil were to in- crease (holding other factors constant)? Give a brief economic explanation for why this
would occur.
f. What would happen to the equilibrium price and quantity if income and the price of oil were both to increase at the same time? Give a brief economic explanation for why this
would occur.
3-25. Input cost increases have caused the industry supply curve for golf balls to shift. The equi- librium quantity changed, but the price did not. Can you say anything about the elasticity of
either the demand or supply curves from observing these effects? Will consumer expendi-
tures on golf balls increase or decrease? Explain.
3-26. Suppose the demand function for a product is P � 100 � (1/6)Q � 2I, where I is income and the supply function is P � (1/3)Q. Currently I � 25. a. Find the current equilibrium price and quantity. b. Suppose the government imposes a $5 per unit excise tax on the product (charged to the
supplier). Find the new equilibrium price and quantity.
c. Draw a graph that shows the equilibriums before and after the tax. Show the areas of the graph that represent the tax borne by consumers and the tax borne by suppliers (together
they add up to the total tax collected). Also depict the deadweight loss imposed by the
tax.
d. Explain in words what the deadweight loss represents. e. What happens if the $5 per unit tax is imposed on consumers rather than suppliers?
3-27. In 1990, Congress adopted a new tax on luxury goods, such as yachts, private airplanes, and jewelry. Assume this was charged as a per unit tax to the consumer. Was this a good way to
accomplish the objective of taxing rich people? Explain.
3-28. Your firm operates in a competitive industry. All firms in the industry have experienced an increase in the cost of raw materials. Do you think that the firms in your industry will be
able to pass the cost increase on to consumers through higher prices? Explain.
3-29. Suppose that the Swiss government wants to encourage good grooming by Thun citizens. To “encourage” better grooming it places a 15 CHF price cap on haircuts (no company can
charge more than 15 CHF for a haircut). The government official who sponsored the new
regulation argued (1) more people will want to get haircuts at a lower price and (2) thus more
people will get haircuts. Do you agree with the economic reasoning of this official? Explain.
3-30. Suppose that the demand curve for wheat is P � 100 � Q and the supply curve is P � Q. Find the equilibrium price and quantity. Calculate consumer and producer surplus. Suppose
that the government imposes a price cap of 30. Show the effect graphically and calculate the
resulting consumer surplus, producer surplus and deadweight loss.
In the United States, top managers (officers and directors) have a fiduciary duty to act in the interests of the corporation and its shareholders. Consistent with this legal obligation, executives constantly profess to the media, stock analysts, and other constituencies a fundamental allegiance to increasing shareholder value, as reflected by the price of the common stock. Some critics, however, contend that managers ignore their legal duty and make decisions that benefit themselves at the
Appendix: Shareholder Value and Market Efficiency
expense of shareholders. We have little doubt that abstract legal principles, like fiduciary duty, are insufficient to induce corporate leaders to maximize shareholder value. However, theory and evidence suggests that there are a variety of internal and external control mechanisms that provide additional incentives to managers to be concerned about shareholder value. We examine these mechanisms beginning in Chapter 10.
Analyzing managerial decisions based on the assumption of shareholder wealth maximization has two benefits. First, it suggests what managers should do to meet their fiduciary responsibilities. Second, it describes what good managers actually do when they have sufficient incentives to focus on shareholder value.
Finance courses analyze investment and financing decisions where it is crucial to consider intertemporal tradeoffs among cash flows. For example, should a manager invest $1,000,000 to build a plant today that has the potential to yield $100,000 per year profit in the future? In contrast, managerial economics largely focuses on opera- tional decisions where intertemporal tradeoffs in cash flows are relatively less impor- tant. For example, what current price should the manager charge to maximize profits? These decisions can be analyzed under the simplifying assumption that managers seek to maximize single-period profits. Little is gained from the added complexity of as- suming that managers seek to maximize shareholder wealth, which involves the valu- ation of multiperiod cash flows.31
In Chapters 4 to 7, we present an economic analysis of demand, production, cost, market structure, and pricing. Here we follow the standard approach in managerial eco- nomics and assume that managers strive to maximize single-period profits. In subse- quent chapters, where intertemporal considerations are more important, we assume that mangers seek to maximize shareholder wealth.
The main text does not require a detailed understanding of stock market valuation. It is sufficient simply to understand that share price incorporates the effects of man- agerial actions on both current and future profits—appropriately adjusted for the timing and risk of the cash flows. In this appendix we go beyond what is necessary for the main text by providing a more detailed analysis of shareholder value. We begin by introducing the concept of present value and deriving an expression for the current value of a share of common stock. We then discuss the concept of stock mar- ket efficiency and its resulting managerial implications.
Present Value Is it better to receive a dollar today or a dollar a year from now? The obvious answer is that it is better to receive the dollar today, since it can be invested to yield more than a dollar in the future. Suppose that you invest a dollar in a risk-free asset (such as a U.S. Treasury security) with a 5 percent interest rate. At the end of one year, your investment will be worth $1.05. The investment, which promises $1.05 for certain in one year, and a dollar today have equivalent value since the dollar can be invested to produce the same future cash flow.32 The future value of a dollar invested in the risk- free asset for one year is $1 � (1.05) � $1.05. Conversely, the present value of $1.05 received for certain in one year is $1.05�1.05 � $1.
31In stationary settings where the same action is optimal in each period, the two objective functions are
equivalent. 32This equivalence of the risk-free investment and the dollar today holds even if the investor wants to consume
a dollar today as long the investment can be sold in the marketplace for its present value.
Chapter 3 Exchange and Markets 115
116 Part 1 Basic Concepts
The concept of present value extends to multiple periods. One dollar invested at 5 percent for n periods is worth $(1.05)n at the end of the nth period. The present value of this future value is $(1.05)n�(1.05)n � $1.00. More generally the present value of W dollars received for certain at the end of n periods is W�(1 � r)n, where r is the risk- free interest rate. For example, suppose that a risk-free investment promises a cash flow of $1.50 in five years and the annual interest rate is 5 percent. The present value of the investment is $1.50�(1.05)5 � $1.175 (investing $1.175 for five years at 5 percent yields a terminal value of $1.50, assuming any intermediate cash flows are reinvested).
Investments often generate multiple cash flows over time. For example, a 10-year U.S. Treasury bond pays a fixed rate of interest every 6 months until the security ma- tures at which time a final principal payment is made along with the final interest payment (20 total payments). The present value of a stream of cash flows is equal to the sum of the present values of the cash flows for each period. The general formula for the present value of a risk-free investment is
Present Value � �CFt�(1 � r)t (3.6)
where CFt is the cash flow that occurs in period t (t � 1 to n, the terminal period). For example, the present value of a 3-year bond that pays $100 at the end of each year and a principal payment of $1,000 at maturity is: 100�(1.05) � 100�(1.05)2 � 1,100�(1.05)3 � $1,136.16 (assuming a 5 percent risk-free rate).
The concept of present value is extremely useful when comparing alternative in- vestments with different time-series patterns of cash flows. Present value allows an “apples-to-apples” comparison of the alternatives since all are expressed in a common dimension—their present values. The best investment is the one with the highest net present value—the difference between the present value of its benefits and costs.
Share Value Our analysis of present value has focused on risk-free investments, where promised fu- ture cash flows were known with certainty and correspondingly discounted by the risk- free rate to obtain present values. Common stocks, however, are risky investments— the ultimate payouts to shareholders are not certain, but depend on the fortunes of the firm. While a firm might be expected to pay a given stream of dividends over time, in- vestors might receive higher or lower payments depending on the fortunes of the firm.
The values of stocks and other risky investments are determined by discounting expected cash flows by risk-adjusted discount rates. The discount rate used for valuing an investment increases with the risk of the expected cash flows. (Finance courses teach that the relevant risk from the perspective of a shareholder who holds this firm’s stock in a well-diversified portfolio is its systematic risk, that which cannot be elimi- nated through holding a diversified portfolio of investments.)
The intuition of stock valuation can be illustrated using a simple example. Suppose that a stock has the potential to pay a liquidating dividend to shareholders of either $50 or $150 at the end of the year. Each outcome has a probability of .5, and thus the expected cash flow is (.5 � $50) � (.5 � $150) � $100. If we discount the $100 expected cash flow at the risk-free rate of 5 percent we obtain $100�(1.05) � $95.24. Purchasing the stock at a price of $95.24 by definition yields an expected return of 5 percent ((100 � 95.24)�95.24). Risk averse investors, however, will not purchase the stock at this price since they can earn the same return for certain by in- vesting the $95.24 in a risk-free asset. For the stock to appeal to a risk-averse investor, it must sell for a lower price and thus offering a higher expected return.
Suppose investors would purchase this stock if it yielded an expected rate of return of 10 percent. The resulting price of $90.91 is found by discounting the expected cash flow of $100 by the risk-adjusted discount rate of 10 percent ($100�1.10 � $90.91).
More generally, companies are expected to last more than one period and may pay dividends in multiple periods. The value of a stock is equal to the sum of the present values of each of the expected future dividends. Expressed in equation form, the cur- rent value of a share of stock, P0, is
P0 � D1�(1 � k) � D2�(1 � k)2 . . . � Dq�(1 � k)q (3.7)
where Dt is the expected dividend paid to the investor at each time t, and k is the risk- adjusted discount rate (expected return).33 Cash flows that are expected to occur fur- ther into the future have less impact on the valuation due to this discounting process. Thus, analysts generally exert most of their effort predicting cash flows over the first 5 to 10 years of the investment. Simplifying assumptions typically are used for esti- mating the present value of the remaining cash flows.
In special cases, Equation (3.7) reduces to simple expressions. One prominent ex- ample is the constant growth model. This model assumes that investors expect the firm’s dividends will grow each period at a constant rate g � k, and that the firm will last forever. It is easy to show that Equation (3.7) reduces in this case to
P � D1�(k � g) (3.8)
Suppose that investors expect that the HG Corporation will pay a $5 dividend at the end of the year and that the dividend will grow at 5 percent annually forever. The price of the stock at the beginning of the year, assuming a risk-adjusted discount rate of .10 percent, is P0 � $5�(.10 � .05) � $100.
Equation (3.8) illustrates that the value of the stock is not determined by the cur- rent dividend alone. Growth firms often pay few dividends in their early years so that internally generated cash can be reinvested in the business. Nonetheless, they can sell at high prices if the market anticipates that they will make large payouts after their growth slows. Consider Microsoft Corporation as its growth rate slowed in 2004. In July 2004, Microsoft announced that it would double its annual dividend to share- holders by $3.5 billion per year, pay a one-time special dividend of $32 billion, and repurchase $30 billion of company stock over the following four years. The special dividend payment was the largest in S&P 500 history and quickly turned Microsoft from a small dividend payer to the tenth highest on the S&P 500 Index.
Stock Market Efficiency Investments with identical cash flows and risk sell for the same price in a well-func- tioning stock market.34 Since rational investors always will purchase the lower- priced of two identical securities, identical securities must sell for the same price for the market to clear (quantity supplied equal to quantity demanded for each security). In equilibrium the expected returns on identical securities are equal.
33Most investors receive part of their returns in the form of capital losses or gains when they sell the stock.
This observation does not invalidate Equation (3.7) since the price of the stock at the time of the sale reflects
the discounted value of the remaining expected cash flows. Also, the equation holds even when some
shareholders receive payouts in the form of share repurchases. 34Other characteristics such as liquidity and tax implications can be valued by the market. For simplicity we
concentrate on risk. The same principle holds in the more general case; investments with identical
characteristics that are valued by the market should sell at the same price.
Chapter 3 Exchange and Markets 117
ANALYZING MANAGERIAL DECISIONS: Shareholder Value and Market Efficiency
1. Suppose that you purchase a newly issued 10-
year U.S. Treasury bond for $10,000. The bond
has a promised interest rate of 5 percent ($250
every six months). The stated interest rate of 5
percent (annual payment of $500 divided by
the initial face value of $10,000) does not
change over the life of the bond. Do you ex-
pect that the market value of the bond will be
constant or variable over the life of the bond?
Explain.
2. Calculate the present value of an investment
with the following expected cash flows at a
discount rate of 10 percent: year 1 � $500, year 2 � $600, and year 3 � $650. Recalculate
the present value at discount rates of 15 per-
cent and 5 percent.
3. Is the discount rate used by investors to value
a given stock necessarily constant over time?
Explain.
4. Find an event reported in today’s business press
that is likely to have an important effect on the
cash flows for a given firm. Use Yahoo’s fi-
nance Web site to produce a chart of the com-
pany’s stock price around the time or day of
the announcement of the event (http://www
.finance.yahoo.com). Explain why the market
reacted the way it did.
118 Part 1 Basic Concepts
A stock market is efficient if it responds quickly and rationally to new information (i.e., share prices fully reflect available information; each stock is priced to yield a competitive return given its risk; stocks are not systematically under- or overvalued). In an efficient capital market, the market values of securities reflect the present values of the expected future net cash flows to shareholders, including expected cash flows from future investments. If an event occurs that changes expected cash flows or risk of a firm, the share price will adjust quickly to reflect the new information. As a result, in- vestors should expect to receive competitive returns from purchasing stocks at current prices (i.e., the market-determined expected return for securities with similar charac- teristics). Depending on the fortunes of the firm, investors may end up earning more or less than the expected return. However, they should not expect to “beat the market” on a systematic basis.
The efficient markets hypothesis is perhaps the most extensively tested hypothe- sis in all the social sciences. The evidence is consistent with the view that stock mar- kets are at least reasonably efficient with respect to public information. Major stock markets react quickly to new information, and investors generally can expect that they will not earn abnormal returns from trading stocks based on publicly available information.
The research on efficient markets has important implications for corporate man- agers. First, there is no ambiguity about the firm’s objective function—managers should maximize the current market value of the firm. Hence, management does not have to choose between maximizing the firm’s current value or its future value, and there is no reason for management to have a time horizon that is too short. Second, management decisions that increase reported earnings, but do not affect current or fu- ture cash flows, represent wasted effort. Third, if new securities are issued at market prices, which reflect an unbiased assessment of future payoffs, then concern about di- lution or the sharing of positive net present value projects with new security holders is eliminated. Fourth, security returns are meaningful measures of firm performance. This allows scholars, management, and analysts to use security returns to estimate the effects of various corporate policies and events on the market value of the corporation.
For example, soon after Hurricane Katrina wreaked havoc on the Gulf Coast in sum- mer 2005, the stocks of property insurance companies fell dramatically, while the stocks of companies such as Home Depot (which sells lumber and other building sup- plies) increased. According to the efficient markets hypothesis these reactions reflect the stock market’s unbiased estimate of the valuation effects of the storm. The evi- dence that security returns are a meaningful measure of firm performance also provides support for using equity-based compensation to provide incentives to top management.
Chapter 3 Exchange and Markets 119
chapter
4 C H A P T E R O U T L I N E
Demand Functions
Demand Curves
Law of Demand
Elasticity of Demand
Linear Demand Curves
Other Factors That Influence Demand
Prices of Related Products
Income
Other Variables
Industry versus Firm Demand
Network Effects
Product Attributes
Product Life Cycles
Demand Estimation
Interviews
Price Experimentation
Statistical Analysis
Implications
Summary
Appendix: Demand
T he Players Theater Company is a regional repertory theater in the Midwest. Each year, it produces six plays, ranging from Shake- speare to contemporary musicals. PTC has priced its tickets at $30. On a typical night, approximately 200 of the theater’s 500 seats are
filled. The PTC board met recently to discuss a possible price decrease to $25 for next season. Advocates of the proposal argued that the decrease in ticket prices would increase the theater’s customer base, the number of tick- ets sold, and revenues for the company.
At the meeting, the PTC board engaged in a heated debate over the pro- posal. It soon became evident that the board had insufficient information to make a sound decision. For instance, nearby restaurants, which serve PTC customers, have indicated that they are planning to implement substantial price increases before the beginning of the next season. Would this increase affect the demand faced by PTC and thus the appropriate ticket price? Al- though customers might buy more tickets at lower prices, would total rev- enue or profits necessarily increase? Would it be better to attract additional customers by lowering price or by improving the quality of PTC plays? After a lively discussion, the proposed decrease in price was tabled for fur- ther study.
This discussion at the PTC board meeting highlights the fact that man- agers require a detailed understanding of product demand to make sound pricing decisions. Understanding product demand also is important for deci- sions on advertising, production levels, new product development, and capi- tal investment projects.
Demand
P A R T T W O M a n a g e r i a l E c o n o m i c s
L E A R N I N G O B J E C T I V E S
1. Define and mathematically express a demand function. 2. Explain the Law of Demand and the connection between declining marginal
value and downward sloping demand curves.
3. Explain price elasticity and its relation to total revenue. 4. Define marginal revenue and discuss its relation to the demand curve, total rev-
enue, and price elasticity.
5. Interpret and explain income and cross elasticities. 6. Identify differences between industry and firm demand. 7. Discuss network effects. 8. Derive and graph demand curve, marginal revenue, total revenue, and price
elasticity when given a linear demand function.
Chapter 4 Demand 121
Chapter 3 offered an introduction to supply and demand analysis. In that chapter, we introduced the notion of a demand curve and discussed some of the factors that can cause a demand curve to shift. In this analysis, we focused on the aggregate de- mand curve for all the firms in the industry. In this chapter we provide a more exten- sive analysis of demand at the firm level. Important topics include demand functions, demand curves, factors affecting demand, industry versus firm-level demand, net- work effects, demand for product attributes, product life cycles, and demand estima- tion. In the technical appendix to this chapter, we derive point elasticities, analyze marginal revenue for a linear demand curve, and examine a special (log-linear) demand function. Most of the analysis in this chapter (e.g., the relation between price and revenue changes) applies to both industry-level and firm-level demand curves. We focus on firm level demand because of its particular importance to managers.1
Demand Functions Managers require a fundamental knowledge of the factors that affect the demand for their product. Only by understanding these factors can they make sound decisions on pricing, output, capital expenditures, and other strategic issues. In fact, poor pricing decisions can destroy firm value and damage executive careers. Kraft Foods demoted the head of its North American business unit, Betsy Holden, after she raised prices and Kraft lost market share. Over this period Kraft’s stock price fell 20 percent while other food companies’ stock prices rose 9 percent.2
A demand function is a mathematical representation of the relation between the quantity demanded of a product and all factors that influence this demand. In its most general form, a demand function can be written as
Q � f (X1, X2, . . . Xn) (4.1)
where the Xi s are those factors that affect the demand for this product. The quantity demanded Q is the dependent variable in the demand function, since
its value depends on the variables on the right-hand side of the equation. The Xi s are the independent variables. In this chapter, we focus on three particularly important independent variables: the price of the product, the prices of related products, and the incomes of potential customers. This analysis can be extended to include other vari- ables, such as advertising expenditures, tastes and preferences, and consumer expec- tations (e.g., about future prices).
For concreteness, we continue to focus on PTC as an example. We assume that PTC faces a demand function for tickets on any given night that can be expressed by the following function:3
Q � 117 � 6.6P � 1.66Ps � 3.3Pr � 0.0066I (4.2)
1The supply and demand analysis in Chapter 3 implicitly assumes that the market is “perfectly competitive.”
As explained later in this book, firm-level demand curves are horizontal in perfectly competitive industries.
The firm-level demand curves in this chapter are downward sloping, which implies that the firm has at least
some “market power.” Most firms have at least a small degree of market power, for example, due to locational
or other advantages in serving a subset of customers. 2S. Ellison and V. O’Connell (2003), “Kraft Removes Holden as Co-Chief,” The Wall Street Journal (December 17), A3 and A8; E. Herman (2005), “Former Co-CEO Holden Leaves Kraft,” Chicago Sun-Times (June 25).
3Note that this function assumes that PTC can sell fractional tickets. This assumption does not have a material effect
on our analysis. However, it allows us to draw continuous demand curves. One way to think of quantity in this
example is as the average number of tickets sold for a performance. In this case, fractional tickets are possible. Note also that we assume that demand is constant for each performance by PTC. PTC performances are all scheduled for
Friday and Saturday nights. If they expand their schedule to include weeknights or matinees, it is likely that demand
conditions for these performances will differ and hence so should prices. These issues are discussed in Chapter 7.
where P is the price of PTC tickets, Ps is the ticket price at a nearby symphony hall, Pr is the average meal price at nearby restaurants, and I is the average household in- come of area residents.
As our starting point, we assume PTC tickets are currently priced at $30; symphony tickets and meals are priced at $50 and $40, respectively; income is $50,000. Given these values, the demand function implies that PTC sells 200 tickets per night. We now examine each of the independent variables in this demand function in more detail.
Demand Curves The price of the product is particularly important in demand analysis for two rea- sons: First, prices are among the most important variables that customers consider in making purchasing decisions. Second, managers choose the price of their products; variables such as the prices of other products and income levels largely are beyond their control. Given its special importance, economic analysis traditionally singles out the effects of price from other independent variables in the demand function.
A demand curve for a product displays for a particular period of time how many units will be purchased at each possible price, holding all other factors fixed.4 The left panel of Figure 4.1 depicts the demand curve for PTC tickets. By convention,
122 Part 2 Managerial Economics
406.6400 400
$ $
60
61
60 Income = $50,000
Income = $51,000
T ic
ke t p ri ce
( in
d o lla
rs )
Q
D D0
D1
Q
Quantity of PTC tickets Quantity of PTC tickets
Figure 4.1 Demand Curves
The left panel shows the demand curve for the Players Theater Company tickets. By convention, price is placed on the vertical axis, while quantity is placed on the horizontal axis. The equation for PTC’s demand curve is: P � 60 � 0.15Q. The curve indicates that, for example, 200 tickets are purchased at $30 and 133 tickets are purchased at $40. The right panel indicates that the demand curve shifts to the right as income increases from $50,000 to $51,000—at each price, consumers buy more tickets. Movements along a demand curve are motivated by changes in price and are called changes in the quantity demanded. Movements of the entire demand curve are motivated by other factors, such as changes in income, and are referred to as changes in demand.
4Technical note: We derive an individual’s demand curve from the indifference curve/budget line analysis in
the appendix to Chapter 2. The price of one good—say, food—is varied, holding the price of other goods and
income fixed. The person’s optimal choices are recorded. The individual’s demand curve simply plots the
optimal choices of the good (in this case, food) against the associated prices. The firm-level demand curve,
in turn, is the sum of the demands of all individuals at each price.
Chapter 4 Demand 123
price is placed on the vertical axis, while quantity is placed on the horizontal axis.5
The equation for PTC’s demand curve is
P � 60 � 0.15Q (4.3)
This expression is obtained by substituting the current values of the other variables into Equation (4.2) and solving for P. The equation indicates that, for example, 200 tickets are purchased at $30 and 133 tickets are purchased at $40.6
Demand curves hold other factors fixed. Changes in income or the prices of sym- phony tickets or restaurant meals will cause shifts in the position of the demand curve (the intercept changes). For instance, the right panel of Figure 4.1 indicates that the demand curve shifts to the right as income increases from $50,000 to $51,000—at each price, patrons purchase 6.6 more tickets. Movements along a de- mand curve reflect changes in price and conventionally are called changes in the quantity demanded. Movements of the entire demand curve are caused by other factors (such as this change in income) and are referred to as changes in demand.
Law of Demand
Demand curves generally slope downward—individuals purchase less (or certainly no more) of a product as the price increases. PTC’s demand curve has a slope of �0.15. Although it is conceptually possible that individuals might purchase more of a product as the price rises, as a practical consideration, managers are quite safe in assuming that the quantity demanded for their products varies inversely with price.7 It would be fool- ish for PTC board members to think that they would sell more tickets if they raised the price. The negative slope of demand curves has become known as the law of demand.
5In subsequent chapters, we consider costs which are a function of quantity produced. Placing P on the vertical axis allows us to display both demand (revenue) and costs on the same graph in a convenient fashion.
6Rounded to the nearest dollar. 7Goods for which the income effect swamps the substitution effect so that consumers purchase more at higher
prices are called Giffin Goods. We ignore this possibility throughout the rest of this book.
M A N A G E R I A L A P P L I C AT I O N S
Learning the Law of Demand the Hard Way Trillions of dollars of products are now sold online. It is not uncommon for companies to make mistakes in posting
online prices. For example, in 2012 United Airlines posted a price of $43 for first-class airline tickets from New York
to Hong Kong—the normal price is around $11,000. In 2013, Walmart accidently posted an $8.85 price for computer
monitors, digital projectors, and other products that normally sell for hundreds of dollars. Consistent with the law of
demand these types of errors typically motivate a rapid and large increase in the number of orders placed by customers.
Online pricing errors are particularly problematic, since potential customers throughout the country or around the
globe view the posted prices. Placing a wrong price tag on an item in a store is typically much less consequential. In
extreme cases, such as the United Airline and Walmart errors, companies often tell customers the price was a mistake
and cancel the orders. However, this action understandably upsets potential customers, who might be less likely to
purchase from the company in the future. Also the legality of canceling orders can be unclear. Companies frequently
honor small pricing errors to avoid upsetting customers.
Source: S. Kim (2013), “Why Walmart Canceled Mispriced Item Orders,” ABC News (November 7); and T. Hume (2012) “Too Good to be True: New York to Hong Kong for $43,” CNN Travel (July 23).
Elasticity of Demand
Demand curves vary in their sensitivity of quantity demanded to price. In some cases, a small change in price leads to a big change in quantity demanded, whereas in other cases a big price change leads to only a small change in quantity demanded. Information on this sensitivity is critically important for managerial decision mak- ing. For instance, the board would not want to lower ticket prices to $25 if it could fill the theater by reducing prices only to $28.
One measure of the responsiveness of quantity demanded to price is simply the slope of the demand curve. But this measure is of limited usefulness, in part be- cause it depends on the particular dimensions in which quantities are quoted. For instance, if the slope of a demand curve is �2 when the quantity is expressed in tons, it is only �0.001 when the quantity is stated in pounds. Using the magnitude of the slope coefficient to derive insights into the sensitivity of quantity demanded to price requires additional computation. Economists more frequently use a di- mensionless measure of this sensitivity known as the price elasticity of demand, �. (Frequently, this elasticity is simply referred to as the elasticity of demand.)
Demand elasticity measures the percentage change in quantity demanded given a percentage change in its price. The law of demand indicates that price elasticities are negative; convention, however, dictates that we state this elasticity as a positive number. Higher price elasticities mean greater price sensitivity. The elasticity of demand, �, thus is given by
� � �(% change in Q )�(% change in P ) (4.4)
124 Part 2 Managerial Economics
ANALYZING MANAGERIAL DECISIONS: Setting Tuition and Financial Aid
The Board of Ursinus College in Pennsylvania
raised its tuition and fees 17.6 percent to $23,460
in 2000. It subsequently received 200 more appli-
cations than the year before. The president of the
college surmised that “applicants had apparently
concluded that if the college cost more, it must be
better.” Other colleges that raised tuition to match
rival colleges in recent years include University of
Notre Dame, Bryn Mawr College, Rice University,
and the University of Richmond. They also experi-
enced an increase in applications. In contrast,
North Carolina Wesleyan College lowered their tu-
ition and fees about 10 years ago by 22 percent and
attracted fewer students. The college president con-
cluded that “it didn’t work out the way it had been
hoped. People don’t want cheap.”
You are hired as a consultant to a President of a
liberal arts college in the East. You are asked to
evaluate a recommendation by the college’s
Admissions Director, Susan Hansen, to increase
tuition and to reduce financial aid to students.
Susan argues that the data from competing colleges
suggest that the demand curves for colleges slope
upward—the quantity demanded increases with
price. Susan projects that the increase in tuition and
reduction in financial aid will solve the school’s fi-
nancial problems. Last year, the college enrolled
400 new students who each paid an effective tuition
of $15,000 (after financial aid), totaling
$6,000,000. She projects that with the increased
demand from charging an effective tuition of
$25,000, the college will be able to enroll 600 new
students (of equal or better quality), totaling
$15,000,000. Evaluate Susan’s analysis and
recommendation.
Source: J. D. Glater and A. Finder (2006), “In Twist on Tuition Game, Popularity Rises with Price,” nytimes.com (December 12).
Chapter 4 Demand 125
Calculating Price Elasticities This elasticity can be approximated between any two points using the concept of arc elasticity.8 The formula for an arc elasticity is
� � �[�Q �(Q1 � Q2)�2] � [�P�(P1 � P2)�2] (4.5) where � represents the change between the two points.9 Figure 4.2 displays two points on PTC’s demand curve for theater tickets. As shown in the figure, the arc elas- ticity between these two points is 1.4. Hence, over this region, for every 1 percent increase in price, patrons reduce the quantity of tickets purchased by approximately 1.4 percent.
Price elasticities lie between zero and infinity. If the price elasticity is zero, quan- tity demanded is unaffected by price. In this case, as depicted in the left panel of Figure 4.3, the demand curve is vertical. If the price elasticity is infinite, a small in- crease in price will lead customers to purchase none of the product. In this case, as displayed in the right panel of Figure 4.3, the demand curve is a horizontal line. For instance, a small farmer might not be able to sell any soybeans if they were priced above the prevailing market price. Demand is elastic if the price elasticity is greater than one, unitary if equal to one, and inelastic if less than one.
Elasticity varies along most demand curves. For instance, with a linear demand curve, elasticity will be high when quantities are low and approach zero as the
M A N A G E R I A L A P P L I C AT I O N S
Walmart Supercenters and Demand Elasticities for Grocery Products Price elasticities usually increase with available substitutes. Over the last 25 years, the price elasticity for grocery products
has increased substantially in many markets where Walmart built supercenters—a substitute for traditional supermarkets
and other grocery stores. Unlike traditional supermarkets, supercenters offer a wide range of products at substantially
discounted prices (e.g., groceries, clothing, home furnishings and electronic equipment). Supercenters are very large
relative to most grocery stores, averaging about 179,000 square feet in 2014. Walmart began establishing supercenters in
the South and Southwest regions of the United States in the late 1980s. It is now the largest grocery market chain in the
country with supercenters in 48 of the 50 states. Researchers have found that the prices for groceries at supercenters are
more than 25 percent lower than at traditional supermarkets prior a Walmart entry. As a result, Walmart entry into a
market motivates competing stores to lower their prices. Walmart supercenters benefit some consumers directly by selling
groceries to them at much lower prices than they paid historically. Consumers, who continue to shop at traditional
supermarkets, benefit indirectly from lower prices at these stores. Not surprisingly, traditional supermarkets oppose
Walmart supercenters. Labor unions also oppose them because the increased competition makes it difficult for traditional
grocery stores to continue to pay the historic level of wages to organized labor. Zoning restrictions and other regulations,
which are endorsed by traditional supermarkets and labor, have blocked Walmart entry in some markets. Consumers in
these markets continue to pay relatively high prices for their grocery products.
Source: J.Hausman and E. Leibtag (2007), “Consumer Benefits from Increased Competition in Shopping Outlets: Measuring the Ef-
fect of Walmart,” Journal of Applied Econometrics and Form 10-K Walmart Stores, Inc., for fiscal year ended January 31, 2014.
8Price elasticity can be measured at a point on the demand curve. The concept of point elasticity requires elementary knowledge of calculus and, more importantly, a smooth mathematical demand curve. While our
example assumes such a curve, data on demand often is available for only a few price-quantity combinations.
We show how to calculate point elasticities in the appendix to this chapter. 9Equation (4.4) can be expressed as � � ��Q �Q � �P�P. When calculating the elasticity between two points, the question arises as to which Q and P to use in this expression, the starting or ending values. Equation (4.5) uses the average of these two values—the initial plus the ending values divided by 2.
126 Part 2 Managerial Economics
400
(133, $40)
� = −[ΔQ/(Q1 + Q2)/2] � [ΔP/(P1 + P2)/2]
(200, $30)
$
60 = −[−67/(200 + 133)/2] � [10/(30 + 40)/2]
= 1.4
Q
D
Quantity of PTC tickets
T ic
ke t
p ri ce
( in
d o lla
rs )
P2
P1
Q1 Q2
Figure 4.2 Arc Elasticity
This figure displays two points on PTC’s demand curve for theater tickets. As displayed in the figure, the arc elasticity between these two points is 1.4. Thus, over this range, for every 1 percent increase in price there is approximately a 1.4 percent reduction in the quantity of tickets purchased.
D (� = 0)
D (� = �)
$
Q Q
$
Quantity Quantity
P ri ce
( in
d o lla
rs )
P ri ce
( in
d o lla
rs )
Figure 4.3 Range of Price Elasticities
Price elasticities lie between zero and infinity. If the price elasticity is zero, quantity demanded is unaffected by price. In this case, as depicted in the left panel of the figure, the demand curve is vertical. If the price elasticity is infinite, as in the right panel, a small increase in price will cause people to purchase none of the product, and the demand curve is a horizontal line.
quantities become large. (Try calculating some arc elasticities along PTC’s demand curve.) We discuss this topic in greater detail later. (In the appendix to this chapter, we present a special demand curve that has constant elasticity—it does not vary along the curve.)
Chapter 4 Demand 127
Price Changes and Total Revenue One of the board’s concerns is how total revenue changes if it lowers ticket prices. We now demonstrate that the relation between revenue and price depends on the de- mand elasticity. Total revenue is calculated by multiplying the quantity purchased times the price (i.e., P � Q ). If price elasticity is inelastic (less than one), then the quantity demanded is less responsive to a change in price; a 1 percent increase in price results in less than a 1 percent decrease in quantity. Thus total revenue in- creases. Conversely, a price decrease results in a decrease in revenue. In contrast, if demand elasticity is unitary (equal to one), a 1 percent change in price results in an offsetting 1 percent change in quantity and hence total revenue is unchanged. Finally, if demand is elastic (value greater than one), a small increase in price results in a de- cline in revenue, whereas a small decrease in price results in an increase in revenue. These relations are summarized in Figure 4.4. We discuss these relations in greater detail below.
Determinants of Price Elasticities The elasticity of demand tends to be high when there are good substitutes for the product. For instance, if a flight is overbooked airlines have little trouble finding
Inelastic demand (� < 1) ↑ P ⇒ ↑ Total revenue ↓ P ⇒ ↓ Total revenue
Unitary elasticity (� = 1) ΔP ⇒ No change in total revenue
Elastic demand (� > 1) ↑ P ⇒ ↓ Total revenue ↓ P ⇒ ↑ Total revenue
Figure 4.4 Price Elasticities, Price Changes, and Total Revenue
How total expenditures on a product change with price depends directly on the price elasticity. This figure displays the relation between small price changes, total revenue, and price elasticities.
M A N A G E R I A L A P P L I C AT I O N S
Price Elasticities Economists have estimated the price elasticities of various products, such as
Sugar � 0.31
Potatoes � 0.31
Tires � 1.20
Electricity � 1.20
Haddock � 2.20
Movies � 3.70
These estimates indicate that sugar and potatoes have relatively low-price elasticities. This might be expected given that
these products represent a small portion of most people’s budgets. Also, sugar has few close substitutes. Haddock and
movies have high elasticities. Haddock is a narrowly defined product (as opposed to fish) and has many close substitutes.
Movies are a luxury item for many people; higher prices cause individuals to consume other forms of entertainment.
Source: E. Mansfield and G. Yohe (2004), Microeconomics (W.W. Norton: New York), 135.
volunteers to surrender their seats when alternate flights are available that involve no material delay in arrival. Conversely, if the overbooked flight is the last of the day, to elicit volunteers might require several free tickets.
The elasticity of demand for PTC tickets is likely to increase with the number of competing events in the city. With many entertainment options, a small increase in the price of PTC tickets might be sufficient to induce a substantial number of potential consumers to attend other events. When alternatives are more limited, additional customers will decide to pay the higher price for PTC tickets rather than just stay at home.
Demand elasticities also can depend on the importance of the goods within con- sumers’ budgets. Goods such as salt and pepper, which consume a relatively small proportion of a person’s income, tend to be relatively price-insensitive, or inelastic. On the other hand, goods such as major appliances and automobiles represent more substantial purchases. Customers are more likely to comparison-shop to collect product information and thus are more likely to be price-sensitive.
A third determinant of price elasticity is the length of the period to which the demand curve pertains. Demand tends to be more elastic or responsive to price changes over a longer period than within a shorter period. An increase in PTC ticket prices is likely to result in an immediate decline in tickets sold. Long-run effects will be even larger as consumers identify other entertainment options or fail to renew season tickets (these effects will cause the demand curve to shift to the left). Similarly, a large increase in the price of oil will result in a near-term de- cline in the quantity of oil demanded—people will set their thermostats to a lower temperature and drive less. Over time, the effect will be larger as consumers in- sulate their homes better, buy smaller, more fuel-efficient cars, and shift to alter- native energy sources.
Other factors that can affect price elasticities include the degree of brand loyalty and whether consumers view the product as a “necessity” or “luxury good.” Branded products with high customer loyalty and products that are viewed as necessities will generally be less price elastic than unbranded products and luxury goods. Consumers vary in what they consider to be necessities versus luxuries. Many people consider sail boats to be a luxury good, but for people who race them for a living, they are more likely to be viewed as a necessity. Differences in the demands for products across potential customers will be explored in more detail in a later chapter.
128 Part 2 Managerial Economics
M A N A G E R I A L A P P L I C AT I O N S
Demand Elasticities and Airline Pricing Round-trip airfares are substantially lower if the traveler stays over a Saturday night. Airline companies offer this
discount to increase revenues (and profits). The typical traveler who stays over a Saturday night is a tourist. Tourists
have relatively high price elasticities for air travel. Lowering the price from the standard fare correspondingly increases
revenue: The price decrease is more than offset by the increase in tickets sold. Airline companies do not offer
comparable discounts to travelers who complete the round-trip midweek. These customers are primarily business
travelers who have relatively inelastic demands. Lowering price would decrease revenue because the decrease in price
would not be offset by an increase in tickets sold. Airline companies also offer fewer discounts during peak periods,
such as the period around the Thanksgiving holiday. During these periods, demand is relatively inelastic and they can
fill the planes without offering substantial discounts.
Chapter 4 Demand 129
Linear Demand Curves
The PTC board’s decision on whether or not to lower prices depends on the relation between price and total revenue and thus its demand elasticity: It would make little sense for the board to lower prices if a price reduction would lower total revenue. We now provide a more in-depth analysis of the relation between price and revenue and discuss the PTC board’s optimal pricing policy. Through this analysis, we illustrate the properties of linear demand curves. Knowing these properties is useful for un- derstanding the subsequent analysis in this book.10
Total Revenue PTC’s total revenue (TR) for any given performance is equal to the quantity of tick- ets sold times the price. Price is given by the demand curve in Equation (4.3). Thus, total revenue can be expressed as
TR � P � Q (4.6) � (60 � 0.15Q )Q � 60Q � 0.15Q 2
Figure 4.5 displays PTC’s demand and total revenue curves. Total revenue in- creases as price decreases up to the midpoint of the demand curve. Over this range, demand is elastic: The percentage decline in price is smaller than the percentage in- crease in quantity demanded. The elasticity is unitary at the midpoint. Past the mid- point, price declines result in reduced total revenue; thus, demand is inelastic over this range. These are general properties of linear demand curves.
Marginal Revenue An important concept in economics is marginal revenue, which is defined as the change in total revenue given a one-unit change in quantity. Intuitively, marginal rev- enue for the first unit is just its price. Thus, the intercepts of the demand and marginal revenue curves are the same. As quantity increases, marginal revenue is below price—to sell an extra unit, the price charged for all units must decrease. Marginal revenue is positive up to the midpoint of the demand curve (total revenue is increas- ing over this interval). At the midpoint, demand elasticity is unitary and marginal revenue is zero. Beyond the midpoint, marginal revenue is negative—the increase in revenue from selling another unit is less than the decline in revenue from lowering price (see the appendix). Hence, marginal revenue (MR) for a linear demand curve is a line with the same intercept as the demand curve but with twice the negative slope (see Figure 4.5). The equation for PTC’s marginal revenue is
MR � 60 � 0.3Q (4.7)
Profit Maximization All of PTC’s costs are fixed and do not depend on the quantity of tickets sold on a given evening—actors and utilities have to be paid regardless of how many people attend the performance. Thus, the PTC board’s objective is to maximize total revenue (for PTC, with costs fixed, maximizing total revenue is equivalent to
10Technical note: This result also can be applied to nonlinear demand curves. At a specific point, construct the
tangent to the demand curve. Now, if the tangency point is at the midpoint of the tangent, the elasticity is
unitary, and so forth.
130 Part 2 Managerial Economics
Inelastic demand (� < 1)
200 Q
Q
D MR
6,000
30
60
$
$
� = 1
Elastic demand (� > 1)
T o
ta l re
ve n
u e
( in
d o
lla rs
) T
ic ke
t p
ri ce
( in
d o
lla rs
)
Quantity of PTC tickets
Figure 4.5 Demand, Total Revenue, and Marginal Revenue for Linear Demand Curves
This figure displays PTC’s demand and total revenue curves in the upper and lower panels. Total revenue increases as price decreases up to the midpoint of the demand curve. Thus, over this range, demand is elastic: The percentage decline in price is smaller than the percentage increase in quantity demanded. The elasticity is unitary at the midpoint. Past the midpoint, price declines result in reduced total revenue; and thus, demand is inelastic over this range. An important concept in economics is marginal revenue, which is defined as the change in total revenue given a unitary change in quantity. In the appendix, we show that marginal revenue (MR) for a linear demand curve is a line with the same intercept as the demand curve but with twice the negative slope. The marginal revenue curve for PTC is pictured in the figure.
ANALYZING MANAGERIAL DECISIONS: Demand Curve for an Electronics Product
You work for a company in India that manufac-
tures and exports batteries and other charge stor-
age devices. You are the sales manager for a DC-
DC converter that is used to step up or step down
the voltage in various industrial applications. You
currently price the product at 4,000 Indian Rupees
(INR) and sell 100,000 units. You estimate that if
you priced the product at 3,000 INR you would
sell 150,000 units.
You think it is reasonable to assume that your
demand curve is linear.
1. Derive the equation for your demand curve
from the two price and sales points.
2. Are you currently operating in the elastic or
inelastic portion of your demand curve?
3. You are paid a sales commission based on your
total sales. What price would you charge to
maximize your bonus?
4. Is this price likely to be optimal from your
firm’s standpoint, which has profit maximiza-
tion as a goal?
Chapter 4 Demand 131
maximizing total profit). Figure 4.5 indicates that revenues are maximized at a price of $30. Hence under current conditions, the PTC board should not lower the ticket price to $25. Currently, the company is collecting $30 � 200 � $6,000 in revenue per night. If the price is decreased to $25, total revenue would be $25 � 233 � $5,825 per night.11 (The upcoming increase in restaurant prices will change the optimal pricing policy. A practice problem at the end of this chapter explores this policy change.)
Note that, in contrast to this example, most firms do not want to maximize total revenue. PTC, with only fixed costs, is a special case. In most firms, both costs and revenues vary with output. A profit-maximizing firm must consider both effects. We discuss these considerations in greater detail in Chapters 5 through 7.
Other Factors That Influence Demand In addition to a product’s own price, the prices of related products and incomes of potential customers are among the more important factors that influence product demand.
Prices of Related Products
Complements versus Substitutes The demand for a product can be affected by the prices of related products. For instance, if the local symphony raises its ticket prices, arts patrons will be less likely to attend the symphony and more likely to attend the PTC. Thus, there is a positive relation in Equation (4.3) between the demand for PTC tickets and the price of sym- phony tickets. Goods that compete with each other in this manner are referred to as substitutes. In contrast, if local restaurants raise their prices, the demand for PTC tickets falls (note the negative sign in the demand function). For instance, some po- tential PTC customers will choose to stay home because the total cost of an evening on the town has increased. Products like theater tickets and meals at restaurants, which tend to be consumed together, are complements. Another example of com- plements is digital video disk players and DVD movies. Between 1997 and 1999, the price of DVD players fell from $600 to $299. Sales of DVD players rose from under 50,000 to 600,000 over these two years. And as consumers experience the better sound quality and video, they also are buying bigger TVs and better sound systems. Big-screen TVs were up 12 percent and audio sales 11 percent. “The
11From the demand curve: $25 � 60 � 0.15Q. Therefore, Q � 233.
M A N A G E R I A L A P P L I C AT I O N S
Complementarity between Computer Hardware and Software Over the past 25 years there has been a dramatic decrease in the price of personal computers. Not only has the price of
PCs decreased, but their quality and computing power have improved substantially as well. This decrease in the price
of personal computers has increased the quantity of PCs demanded enormously. In addition, it also has increased the
demand for software products. Today, some of the largest companies in the world (e.g., the Microsoft Corporation)
specialize in writing of software for PCs. Computer hardware and software are complements and thus have negative
cross elasticities.
132 Part 2 Managerial Economics
biggest market driver is DVD,” said Terry Shimek, owner of Shimek’s Audio Video in Anchorage, Alaska. Moreover, the demand for DVD movies increased as well. Initially caught flat-footed, Hollywood started making more movies available on DVD. The number jumped from 1,800 in 1988 to 5,000 in 1999. (That is compared to 18,000 on VHS tape.)12
Cross Elasticities One frequently used measure of substitution between two products is the cross elas- ticity of demand. Cross elasticity is defined as the percentage change in the quantity demanded of a good, given a percentage change in the price of some other good. Cross elasticities between any two goods, X and Y, can be calculated using a formula that is analogous to Equation (4.5):
�xy � [�Qx�(Qx1 � Qx2)�2] � [�Py�(Py1 � Py2)�2] (4.8)
Unlike price elasticities, which are invariably positive (at least when you multiply them by �1), cross elasticities can be either positive or negative—substitutes have positive cross elasticities whereas complements have negative cross elasticities. Whether a commodity has strong substitutes or complements depends, in part, on how finely the commodity is defined. Pepsi and Coke might have relatively large cross elasticities. The cross elasticities between colas, more broadly defined, and other soft drinks are likely to be smaller.13
Cross elasticities are useful because managers frequently want to forecast what will happen to their own sales as other companies change their prices. The PTC board is concerned about the effects that a forthcoming increase in restaurant prices would have on its ticket demand. If meals in local restaurants and theater tickets are strong complements, a substantial increase in restaurant prices would cause a serious decline in the demand for PTC tickets. In this case, the PTC board might want to off- set this shift in demand by lowering ticket prices or advertising more heavily. In con- trast, if meals and tickets are weak complements, the increase in meal prices would have little effect on ticket demand. In our example, a $10 increase in meal prices will result in 33 fewer ticket sales per night. Using the formula in Equation (4.8), the cor- responding cross elasticity between these two points [(200, $40); (167, $50)] is
M A N A G E R I A L A P P L I C AT I O N S
Derived Demand Some products are demanded, not because individuals receive pleasure from consuming them, but rather because they
are useful in the consumption of other products. Demands for these products are derived from the demands from other
products. Take motor oil, for example. Few people derive satisfaction from purchasing oil for their automobiles.
Rather, it is a derived demand from consuming transportation services provided by their cars. Procter & Gamble
(P&G) discovered that spraying a bit of their Clean Shower bathroom cleaning product on a razor each day can extend
the razor’s life three or four times. They are formulating a product targeted to this use. Thus, this new product’s
demand is derived from the demand for razor blades.
12E. Ramsted (1999), “As Prices Tumble, Sales of DVD Players Explode for the Holidays,” The Wall Street Journal (December 9), 31.
13Next, we extend this discussion to show how cross elasticities can be used by managers to define a firm’s
industry.
Chapter 4 Demand 133
�0.81: For every 1 percent increase in meal prices over this range there is, on average, a 0.81 percent decline in ticket sales. This elasticity suggests that PTC tickets and restaurant meals are rather strong complements.
Income
Normal versus Inferior Goods Another factor that frequently affects the demand for a product is the income of po- tential buyers. As a person’s income increases, more products are purchased, and the combined expenditures across all products rise. The demand for specific products,
M A N A G E R I A L A P P L I C AT I O N S
Estimates of Cross Elasticities Economists have estimated the cross elasticities for various commodities. Below are a few of these estimates:
Electricity and natural gas � 0.20
Beef and pork � 0.28
Natural gas and fuel oil � 0.44
Margarine and butter � 0.81
All the pairs of commodities listed above are substitutes. Complements such as DVD players and DVD movies have
negative cross elasticities. Natural gas apparently is not a very strong substitute for electricity. Although people can use
either gas or electricity for heating, natural gas is not generally used for lighting. On the other hand, natural gas and fuel
oil are closer substitutes (both tend to be used for heating). Margarine and butter are strong substitutes. Note that the cross
elasticities for some goods depend on how much time consumers have to adjust to changes in relative prices. For example,
the cross elasticity between natural gas and fuel oil is likely to be much higher in the long run, since it takes time to
replace old furnaces and other equipment with newer equipment powered by the less-expensive fuel source. In contrast,
customers can adjust to a relative change in the prices of margarine and butter on their next trips to the grocery store.
Source: E. Mansfield and G. Yohe (2004), Microeconomics (W. W. Norton: New York), 135.
M A N A G E R I A L A P P L I C AT I O N S
Cross Elasticity and Pfizer’s Lost Profits in Japan Pfizer, the world’s largest pharmaceutical company, produces the leading drug to help people quit smoking. It is
marketed under the brand name of Chantix in the United States and Champix in Japan. According to the Wall Street Journal, Pfizer lost millions of dollars of potential sales by underestimating the cross elasticity of demand between Champix and cigarettes. On October 1, 2011 the price of cigarettes increased significantly in Japan due to a
government tax. Tens of thousands of people, who wanted to quit smoking, went to their doctors for prescriptions of
Champix. Unfortunately, Pfizer had produced far too little of the drug to meet the demand. Clinic directors were upset
and argued, “they should have predicted something like this.” After all, Pfizer had known about the planned tax
increase for over a year. A Pfizer spokesman responded to these complaints by stating, “we expected more demand, but
not to this extent.” Whether or not Pfizer could have predicted the very large cross elasticity between Champix and
cigarettes with available data and information remains an open question. But had they done so, they would have
increased their revenues and profits by potentially millions of Yen.
Source: H. Tabuchi (2011), “In Japan, Pfizer is Short of Drug to Help Smokers, The Wall Street Journal (January 3).
however, can either rise or fall as income increases. The demand for goods such as gourmet foods or jewelry would be expected to increase with income, whereas the demand for other goods like canned processed meat or cabbage might decline. Goods for which demand increases with income are called normal goods. PTC tick- ets are normal goods. Goods for which demand declines with income are called inferior goods.
Income Elasticities The sensitivity of demand to income is measured by their income elasticity. The in- come elasticity is defined as the percentage change in the demand for a good, given a percentage change in income (I). Income elasticities can be calculated using the following formula.
�I � [�Q �(Q1 � Q2)�2] � [�I�(I1 � I2)�2] (4.9)
The income elasticity is positive for normal goods and negative for inferior goods. The income elasticity of a firm’s product has important implications. Firms pro-
ducing products with high income elasticities are more affected by cyclical fluctua- tions; they tend to grow more rapidly in expanding economies but contract more sharply in depressed economies. Managers must anticipate these fluctuations in managing cash flows and hiring decisions. Demands for products with small income elasticities are more stable over economic cycles. Studies indicate that goods like do- mestic servants, medical care, education for children, and restaurant meals tend to have relatively large income elasticities, whereas goods such as most food products, gasoline, oil, and liquor have relatively small (in absolute value) income elasticities.
Income elasticities also can influence location decisions. For instance, PTC has a relatively high-income elasticity (above 1.6). This elasticity was one of the factors that motivated the founders to locate their theater in a community with a high per capita income. They anticipated that they would have fewer customers if they located in a less affluent area.
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Estimates of Income Elasticities Economists have estimated the income elasticities for various products. Below are a few of these estimates:
Flour � �0.36
Margarine � �0.20
Milk � 0.07
Meat � 0.35
Dentist services � 1.41
Restaurant consumption � 1.48
According to these estimates, flour and margarine are inferior goods. People spend less on these goods as their
incomes rise. The other goods are normal goods (expenditures on the products rise with income). Dentist services and
restaurant consumption are particularly sensitive to income changes.
Source: E. Mansfield and G. Yohe (2004), Microeconomics (W. W. Norton: New York), 135.
Chapter 4 Demand 135
Other Variables
We have concentrated on three of the more important independent variables in most demand functions—the product’s own price, prices of related products, and income. Other variables, such as advertising expenditures, also can be important. In all cases, the analysis is similar. Demand responds to a change in some other variable. Sensi- tivity can be measured by the appropriate elasticity—for instance, an advertising elasticity. Obviously, managers do not have the time to consider all the conceivable variables that might have trivial impacts on the demand for their products. Good de- cision making requires that managers understand the effects of the more important factors, which usually include the product’s own price, the prices of close substitutes and important complements, and incomes.
Industry versus Firm Demand Industry Demand Curves Although we have concentrated our analysis on firm-level demand, demand func- tions and demand curves can be defined for entire industries. For instance, a demand function could be specified for the entertainment industry in PTC’s market area. Such a function would relate the total ticket sales for all entertainment events to fac- tors that affect this demand. Managers often are interested in total industry demand because it provides important information on the size of their potential markets and trends that affect them. For instance, a company’s executives might judge the perfor- mance of a store manager that reports flat sales quite differently if market demand is shrinking and the store is increasing market share versus a case where market de- mand is increasing but the store is losing market share. Moreover, estimates of in- dustry demand sometimes can be obtained at modest cost from outside analysts or business publications.
Firms within an industry compete directly and their products are likely to be rel- atively strong substitutes. The overall industry, on the other hand, is less likely to have strong substitutes. A person wanting to go to an entertainment event might
M A N A G E R I A L A P P L I C AT I O N S
A Pampered Dog Loses His Stylist Even wealthy consumers are affected by changes in income. Consider Betsy Illium, a marketing consultant to medical
practices, who owns four Manhattan apartments (three are investment properties). In early 2008, Illium became
concerned that her income would decline given forecasts of a looming economic recession. “It’s frightening,” she said,
with much of her wealth being tied up in real estate. In response she decided to replace her dog Dobbin’s regular
groomer, who charged $130, with one from Petco, which charged only $65. She also decided to send her dirty sheets
and towels to a laundry service rather than to a higher priced dry cleaner. In her case, high-priced dog groomers and
dry cleaning are normal goods (her demands for these products increase with income), while laundry services and low-
priced dog groomers are inferior goods (her demands for these products decreased with income). Illium became
“appalled when she calculated that Dobbin’s grooming, her own weekly hair, nail and massage appointments, gourmet
groceries, restaurant meals and Starbuck’s coffee cost nearly $2,000 a month.” She realized that she would have to
“tighten her alligator belt” due to the threat of recession.
Source: S. Rosenbloom (2008), “Tightening the Alligator Belt,”nytimes.com (January 27).
choose among several options based on price. Entertainment events more broadly defined have fewer alternatives. Thus, demands facing individual firms within an industry tend to be more price-elastic than those for the entire industry.
Defining Industry and Market Area We have indicated that managers can gain important insights by analyzing industry- level demand. One problem that managers face in conducting this type of analysis is defining the relevant industry and market area. Is PTC competing in the live theater
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9/11 Causes Massive Shifts in Demand Curves The 9/11 terrorist attacks on the World Trade Center and Pentagon caused the demand curves for numerous goods and
services to shift. Consider the following examples of industries whose demand curves shifted left:
• Hotels lowered room rates by 30 to 40 percent. Marriott Hotels put a third of its hourly employees on part-time
schedules.
• Disney trimmed the hours at its theme parks and reduced the hours of 40,000 part-time workers.
• The U.S. airline industry estimated that 9/11 caused it to lose about $7 billion and saw its revenues drop by
40 percent. Following 9/11 many planes flew at less than 50 percent capacity and airlines laid off 20 percent of
their workforce. The U.S. government provided $15 billion of loan guarantees to the airline industry.
• Spot prices for crude oil plummeted to a two-year low of $20 per barrel.
But not all firms saw the demand for their goods and services adversely affected by 9/11. The following firms saw their
demand curves shift to the right:
• Sales of American flags skyrocketed. Annin & Co., a 675-employee flag maker and market leader, increased
output of its most popular 3-by-5-foot U.S. flags from 30,000 to 100,000 a week by October 2001. Its five
plants added shifts, but dealers still had to wait 15 weeks for delivery of popular-size flags.
• The demand for biometric systems increased. Biometric systems identify people using digital face, iris, or
fingerprint scans. The biometric trade association doubled its worldwide revenue growth forecasts following
9/11. The three largest publicly traded biometric firms’ stock prices rose on average 70 percent when the stock
markets reopened on 9/17.
• InVision Technologies, which makes bomb-detection systems for airports that cost between $750,000 and
$1.5 million each, saw its stock price increase 165 percent on the first trading session after the markets
reopened.
• The U.S. government increased the defense department’s budget by $10 to $15 billion. A significant percentage
of those funds were expected to be spent on intelligence technologies, such as those produced by software
companies like Narus, which track and sort data and e-mail on the Internet to identify potential terrorists.
On average, publicly traded companies suffered significant reductions in demand. For instance, the stock market
suffered its worst one-week loss since the Great Depression; following 9�11 stocks lost $1.2 trillion in market value. Nonetheless, there were winners scattered among the larger population of losers.
Source: E. Brown (2001), “Heartbreak Hotel?” Fortune (November 26), 161–163; M. Gunther (2001), “The Wary World of Disney,” Fortune (October 15), 104; K. Marron (2002), “Systems That Use Physical Traits to Control Access to Sensitive Data Are Catching On in Post-Sept. 11 Era,” The Globe and Mail (March 28), B16; B. O’Keefe (2001), “Securing the Air, One Bag at a Time,” Fortune (October 15), 244; B. Powell (2001), “The Economy under Siege,” Fortune (October 15), 87–108; J. Simons (2001), “Greed Meets Terror,” Fortune (October 29), 145–146; S. Tully (2001), “From Bad to Worse,” Fortune (October 15), 118–128; D. Voreacos (2001), “As Country Wraps Itself in Flags, Company Strains to Make Them,” Houston Chronicle (October 7), 10; M. Warner (2001), “Web Warriors,” Fortune (October 15), 148.
Chapter 4 Demand 137
14Cross elasticities also are used as evidence in antitrust cases. Antitrust cases generally focus on whether or
not a company has significant market power within an industry. Thus, the definition of the industry is quite
important. A company might have a significant market share (and thus apparent power) in a narrowly
defined industry, but a small market share in a more broadly defined market. For instance, the government
suggested that the ReaLemon Company had monopolized the reconstituted concentrated lemon juice
market—supplying over 90 percent of that market. The company responded that the appropriate market
definition was broader: They faced vigorous competition from reconstituted natural-strength lemon juice,
fresh lemons, frozen lemonade, lime juice, and so on.
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Store Layout Affects Demand Paco Underhill calls himself a “retail anthropologist.” His consulting firm videotapes consumers as they shop at his
clients’ stores such as Sears, The Gap, and McDonald’s. He then offers recommendations for store layout. For
example, most North Americans turn right after entering a store while most British and Australian customers turn left.
Consumers tend to avoid narrow aisles; they apparently dislike being jostled from behind (what he calls the “butt-brush
factor”). Junk food should be placed on low or middle shelves so kids can reach them. After finding that women spend
only half the time in the store when accompanied by a man, he recommends placing numerous chairs around stores so
men can sit comfortably while the women shop.
Source: K. Labich (1999), “Attention Shoppers: This Man Is Watching You,” Fortune (July 19), 131–133.
industry or in a more broadly defined entertainment industry? Cross elasticities pro- vide important information to answer these types of questions. The cross elasticity be- tween PTC tickets and symphony tickets is 0.4. This relatively high value (see the box titled Estimates of Cross Elasticities presented earlier in this chapter) suggests that PTC competes against companies in a broader entertainment industry than just live theater.14 The managers at PTC also must define the relevant geographic area of their marketplace. If PTC raises its prices, will its customers shift to theaters in other nearby cities? If so, these cities should be included in the definition of PTC’s market area.
Network Effects For some products, demand increases with the number of users. For example, fax machines and telephones are not particularly useful unless there is a network of users. This consideration is quite important for many of today’s communication and information products. For instance, consumers were reluctant to buy new products, such as 3-D television sets, Blu-ray players, and new word processing programs, until they became convinced that the products had the potential for widespread use. Consumers understand that if a product does not garner sufficient demand, important complementary products, such as Blu-ray movies, will not be produced in high volumes or at attractive prices. Also they worry that it will be dif- ficult to acquire reliable, inexpensive service for the new product. They may learn to use a new technology only to find that it is discontinued because of insufficient demand. For example, despite vigorous efforts by Sony to promote its Betamax technology for video recording, the technology was displaced completely by the VHS format. VHS suffered a similar fate from DVDs and Blu-ray.
Products where these network concerns are important often have relatively elastic demands. When price is lowered, there are two effects. One is the standard price
effect: Consumers purchase more of the product because it is being sold at a more at- tractive price. The second is the network effect: Demand for the product increases even more because more people are using the product. When a new consumer purchases the product, there is an externality for other users; because there is an additional user of the product, the product becomes more attractive for other current and potential users.
Network effects have important implications not only on product pricing, but on product design as well. For instance, when software manufacturers are designing software upgrades, they have to decide whether to make the new product compatible with prior versions of the software and with competing products on the market. Mak- ing a new product compatible with competing products can reduce the uniqueness of the product. However, the net effect can be to increase overall demand for the prod- uct because of network effects. For example, a consumer might be more willing to buy an Apple computer if it is compatible with Windows computers because of the enhanced ability to interact with Windows users.
Product Attributes Thus far, we have taken the attributes of the product as given. Our analysis of the de- mand for PTC tickets is based on the existing quality and selection of plays, their starting times, the quality of seating, and so on. Given these characteristics, we ex- amined how price and other factors affect the demand for PTC tickets.
Understanding consumer demand also plays an important role in the design of the product. For instance, do local patrons prefer Shakespeare or more contemporary
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Demand Elasticity for Gasoline The industry-level demand for gasoline is relatively inelastic: The price of gasoline can change substantially and have
little effect on the overall quantity demanded. The demand elasticities facing individual gas stations are much larger. If
several gas stations are located at the same intersection, an individual station can suffer a remarkable loss of business to
its local competitors by raising its price.
M A N A G E R I A L A P P L I C AT I O N S
eBay and Network Effects The largest online auction site, eBay, is one of the few thriving dot-coms. Recently it has been growing at 72 percent
per year. It had reported profits of $90 million in 2001 on revenues of $749 million and attracted 37 million customers
per quarter. Over a million sellers offer products on eBay. Many sellers work full-time selling products over eBay; for
example, Angie Cash sells $10,000 a month of items that cost no more than $20 each. eBay does lots of things right
such as clever e-mails, message boards, and a self-monitoring system whereby buyers and sellers rate each other’s
performance. eBay is a trading platform that exploits network effects. The demand for eBay increases as the number of
buyers and sellers increases. More sellers increase the chance that buyers will find what they want, and more buyers
increase the chance sellers will sell their products at higher prices.
Source: E. Brown(2002), “How Can a Dot-Com Be This Hot?” Fortune ( January 21), 78–84.
Chapter 4 Demand 139
plays? Do they prefer mysteries or musicals? Do they value comfortable seating with additional leg room or seating that is closer to the stage? Can the anticipated de- crease in demand from increased restaurant prices be offset by changing the starting time of the plays? (Delaying the starting time by 30 minutes might give people more time to eat at home before going to the play.)
Answers to these types of questions are important in managerial decision making and establishing corporate strategy. Indeed, when managers speak of the importance of understanding consumer demand, they often are referring to understanding the specific product attributes that are important to customers. Marketing managers are responsible for understanding the broad range of product attributes that affect de- mand. These include price, product design, packaging, promotion and advertising, and distribution channels.15 This broad focus on demand has played an especially important role in management innovations like total quality management programs (see Web Chapter 23, available via Connect).
An important problem facing most firms is how to incorporate information that may be held by many people throughout a firm—for example, about such matters as consumer demand—into the decision making process for product design. We defer discussions of this problem until the last half of this book. These sections provide in- sights into how to design the firm’s organizational architecture to help ensure that relevant information is incorporated in the decision making process.
Product Life Cycles Our discussion of product attributes suggests that managers constantly seek to de- velop new and better ways to identify and respond to consumer demands. This ac- tivity leads to the introduction of new products. Managers generally recognize that market demand for a new product is unlikely to remain stable over time. Often, the
15For a more formal economic analysis of the demand for product attributes, see K. Lancaster (1966), “A New
Approach to Consumer Theory,” Journal of Political Economy 74, 132–157.
M A N A G E R I A L A P P L I C AT I O N S
Understanding What Consumers Want Innovative companies strive to develop new products that will be demanded by customers. Managers, however, vary in
their beliefs about the best way to discover consumer demand. Steve Jobs, former CEO of Apple Inc., thought that
consumer surveys and other market research were relatively useless, since consumers often don’t know whether they
will purchase a new product until they see it. Many industry “experts” were highly skeptical about the potential demand
for iPads when the product was first announced. They criticized Jobs for not conducing market research prior to the
launch. Jobs, however, strongly believed that consumers would want to purchase the product once they experienced it,
and he was right. Henry Ford, the founder of Ford Motor expressed this same belief about market research when he
famously said, “If I had asked people what they wanted, the would have said faster horses.” Jim Goodnight, one of the
founders and long–time CEO of SAS, strongly believed that it is critical for his company to obtain ideas and suggestions
from customers about potential new software products. SAS has successfully developed an expanding range of new and
upgraded software products for nearly four decades. In 2013, it employed 13,764 people and had sales of over $3 billion.
While these CEOs differ in their beliefs about the value of market research, all three were highly successful in managing
their companies and in introducing new products that were highly demanded by customers.
Source: W. Isaacson (2011), Steve Jobs (Simon & Schuster) and SAS Overview and Annual Report 2013.
industry demand curve for a new product shifts outward as the product becomes more widely known. Eventually, however, the demand is likely to shift inward as consumers shift toward other new and improved products. This pattern in the de- mand for new products is known as the product life cycle.
As depicted in Figure 4.6, the product-life-cycle hypothesis suggests that the de- mand for a product can be categorized into four main phases: introduction, growth, maturity, and decline. In the growth phase, the industry-level demand increases rapidly. In the maturity phase, the demand continues to increase and then begins to decrease. In the decline phase, the demand continues to fall. Eventually, the product is withdrawn from the market. Managers should recognize these trends in new- product planning, as well as in entry, exit, and pricing decisions for given products.
The increase in demand during the growth phase encourages new firms to enter the industry. For instance, the growth in the demand for personal computers (PCs) during the 1990s prompted many firms to begin production. Given the entry of new firms, original firms typically lose market share. If industry demand grows at a faster rate than the number of firms, existing firms realize sales growth, even though their market
140 Part 2 Managerial Economics
In du
st ry
q ua
nt ity
o f o
ut pu
t
Time T
Introduction Growth Maturity Decline
Product life cycle
QFigure 4.6 Product Life Cycle
The product-life-cycle hypothesis suggests that the industry demand for a new product goes through four main phases: introduction, growth, maturity, and decline.
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Demand for Prostitutes Declines in the United States Over Time The demand for goods and services frequently changes over time. Popular media opinion is that the demand for
prostitutes, “the world’s oldest profession,” is booming in the United States. The evidence, however, suggests
otherwise. The sexual mores are much more liberal today than they were a century ago. It is generally much easier for
men to find premarital “hookups.” The increased supply of noncommercial sex appears to have reduced the demand for
prostitutes. In 1948, 69 percent of men surveyed indicated that they had paid for sex at least once, while in 2006 the
percentage was only 15. Consistent with basic supply and demand analysis, the decline in demand has been
accompanied by a decrease in the price paid to street prostitutes. The average annual income for prostitutes is
estimated to have declined from $25,000 per year to $18,000 per year (both in 2007 dollars) over the period
1911–2007.
Source: (2014) “Sex, Lies and Statistics,” The Economist (March 22).
Chapter 4 Demand 141
share falls. If the number of new firms grows faster than industry demand, existing firms will experience a reduction in demand, depressing prices and firm profits.
This discussion suggests that the first firms to introduce a successful product sometimes can have “first-mover advantages.” In this case, they enjoy high profits until competitive entry occurs. They also can develop a customer base and have a longer time period to learn how to produce the product efficiently. These advantages explain why firms frequently strive to be the first to develop and launch new products. However, in attempting to exploit an innovative product, managers must anticipate the impact that their policies are likely to have on entry decisions by potential rivals.
The analysis also suggests that managers should be careful in evaluating whether to enter an industry during its growth phase. Competition during this phase can be intense; moreover, the demand they face is expected to decline at some point in the future. To prosper in such an environment, a new firm must have some type of competitive advantage over its rivals (e.g., being a low-cost producer).
Demand Estimation16
In our PTC example, we know the demand function. Most managers are not so lucky: They must estimate their demand functions. Sometimes it is easy to estimate demand, at least for the very near term. Other times it is quite difficult. Some com- panies employ statistical techniques to provide numerical estimates of demand func- tions. Other companies use more qualitative approaches.
Demand estimation is a complex topic that is largely beyond the scope of this book. Here, we simply provide a brief discussion of three general techniques used in estimating demand: interviews, price experimentation, and statistical analysis. Our intent is to provide insights into the basic costs and benefits of each approach. These insights make managers more informed consumers of demand estimates and offer guidance as to the type of demand analysis to employ in a given situation. Although each approach has its limitations, the approaches are not mutually exclusive. Be- cause the limitations differ, many managers employ several methods and aggregate the estimates to increase their understanding of demand.
Interviews
Interview approaches attempt to estimate demand through customer surveys, ques- tionnaires, and focus groups. Perhaps the most naive version of this approach is simply to ask consumers what they would purchase if faced with different prices. The answers to these questions can be remarkably unreliable. First, people have in- centives to be less than completely truthful since customers would like the firm to offer lower prices. Second, even if they try to be truthful, they might have difficulty forecasting what they would actually purchase given the array of alternatives avail- able in the marketplace.
More sophisticated approaches to customer interviews are possible. For example, an individual might be asked about the difference in price between two competing products. Now if you found that individuals had purchased one of the products but
16This section draws on W. Baumol (1977), Economic Theory and Operations Analysis (Prentice Hall: Englewood Cliffs, NJ), 234–236.
did not know the price of the other, you might conclude that customers were rela- tively insensitive to price.
Sometimes companies use a simulated market where people are given play money and asked to simulate purchase decisions. These experiments can yield useful in- sights. Again, however, the decisions people make with play money need not mirror the decisions they would make with their own money.
Consumer surveys play a particularly important role in providing information about the attributes that are valued by customers. Many businesses request that buy- ers fill out customer-service and complaint forms. Businesses often follow up sales or service with telephone calls to customers to ask about product and service quality and customer satisfaction. Among the most important sources of information about customer preferences are the direct contacts that salespeople and other company rep- resentatives have with their customers.
All the interview approaches, however, can produce remarkably inaccurate in- formation if the sample is not representative of the population of the firm’s cus- tomers. For instance, if you are interested in estimating demand for a good with a negative income elasticity, distributing surveys at an upscale mall might be a poor way to proceed. More subtle problems with eliciting interview information also can arise. One team of researchers cautions, “The curious, the exhibitionistic, and the succorant are likely to overpopulate any sample of volunteers. How secure a base can volunteers be with such groups over-represented and the shy, suspicious, and inhibited under-represented?”17
Price Experimentation
A second approach is to undertake price experiments. For instance, the board might decrease PTC’s ticket price to $25 and carefully track changes in ticket sales. However as part of the company’s marketing strategy, PTC prints brochures that detail the sea- son’s plays, costs, dates, and ticket prices. Thus, experimenting with their ticket prices would require reprinting their brochures. This raises the cost to PTC of this type of price experimentation. Some other types of firms incur few costs in changing prices; for instance, it is particularly easy for companies that market through the Internet to experiment with their prices.
Many firms are unlike PTC in that they operate at multiple locations. If a firm has the flexibility to vary prices across different geographic markets, it has the potential to gain more information than if it is limited to experimenting at a single location. But care must be exercised. Ideally, the local markets are separated geographically and have their own media outlets. Thus advertising lower prices in one market will not shift demand from the firm’s other locations.
There are at least three limitations in the use of price experimentation. First, de- mand can differ, depending on whether customers anticipate that a price change will be permanent or temporary. It can be difficult to identify customers’ expectations about future prices. Second, direct-market tests are not controlled experiments; sev- eral changes might be occurring simultaneously. For instance, the board might lower PTC’s ticket prices at the same time that the symphony changes its prices. The observed change in demand would reflect both effects. Third, some managers worry
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17E. Webb, D. Campbell, R. Schwartz, and L. Schrest (1966), Unobtrusive Measures (Rand McNally College Publishing Company: Chicago).
Chapter 4 Demand 143
On Estimating Demand Curves for Common Stocks There has been a long-running debate over the demand elasticities of common stocks of individual firms. Many
economists argue that these demand curves are perfectly elastic, since there are numerous stocks with similar risk-
return characteristics available in the market. In this case, the demand curves for individual stocks are horizontal.
Others argue that each stock is unique and has very few substitutes. Here, the individual demand curves would be
downward-sloping.
Managers care about the slopes of the demand curves for their common stock since these slopes affect the price
at which they can sell new securities. If demand curves slope downward, price must be decreased below the current market
price to sell new securities. If demand curves are horizontal, new securities can be issued at the current market price.
Managers, of course, want to sell new stock at the highest possible price.
The existing empirical evidence suggests that stock prices decline by about 3 percent when firms announce new
issues of common stock. This finding seems to suggest that the demand curves for common stocks are downward-
sloping. This finding, however, is subject to alternative interpretations. If investors think that managers tend to issue
new stock when they believe it is overvalued, an announcement of a new issue will cause the entire demand curve to
shift down and price will decline (since investors infer from the announcement that the firm is overvalued). The
observation that price declines when new stock is issued is not sufficient to allow us to identify the price elasticity of a
firm’s common stock—the price decrease might be due to either a shift in demand or a shift in quantity demanded.
This example illustrates that it is not always easy to estimate demand curves, even when extensive data on prices
and quantities are readily available. Indeed, the data on prices and volumes for publicly traded securities are among the
best available in the world.
Source: C. Smith (1986), “Investment Banking and the Capital Acquisition Process,” Journal of Financial Economics 15, 3–29.
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that price experimentation is risky. They are concerned that customers lost as a result of a price increase might be difficult to regain even if subsequently the price were lowered. Alternatively, it might be difficult to raise the price once a firm had lowered it (customers might be annoyed and purchase from rivals).
Statistical Analysis
Often, companies use statistical techniques such as regression analysis to estimate demand functions. Computers and large databases on sales, prices, and other relevant factors have increased the usefulness of this approach materially. By using statistical techniques, the effects of specific factors often can be isolated. It is possible to ana- lyze large samples of actual market data to obtain more reliable results.
Even though statistical approaches can provide managers with important infor- mation on demand, they must recognize that there are potential problems. Just be- cause a researcher can produce reams of computer output formatted into tables and multicolored graphs implies neither that the analysis is well done nor that the results are reliable. Below, we briefly discuss three types of problems that managers en- counter regularly in statistical approaches to estimating demand.
Omission of Important Variables The problem of omitted variables can be illustrated by an example. Assume that the actual demand function for a company is
Sales � 120 � 2P � 8A � 0.04I (4.10)
where P is the price of the product A is advertising expenditures I is income
Table 4.1 presents the data for 2006, 2007, and 2008. While this data is potentially available to the marketing manager, Brendis Isaccsdottir, who wants to estimate de- mand, does not necessarily know that both advertising and income are important de- terminants of demand. Suppose that Brendis ignores income and uses statistical techniques to estimate a relation between sales and advertising.18 Standard regres- sion techniques would yield the following equation:
Sales � 140 � 48A (4.11)
The model appears to predict sales perfectly (based on the data in the table). The equation, however, materially overstates the true influence of advertising and can lead to spectacular mistakes in decision making. Based on this analysis, Brendis might budget far too much for advertising. This omitted-variables problem is present when- ever important excluded variables are correlated with explanatory variables that are included in the statistical analysis.19 Including unimportant variables does not bias es- timated coefficients for the other variables (however, including irrelevant variables re- duces the precision of the various estimates).
Multicollinearity If the factors that affect demand are highly correlated (tend to move together), it might be impossible to estimate their individual effects with much precision. For in- stance, two important variables in the demand function might be income and educa- tion. If in the data set to be analyzed high income is always associated with high ed- ucation, it might be impossible to separate the two effects.
144 Part 2 Managerial Economics
2006 2007 2008
Income (I) $3,000 $4,000 $3,500 Advertising (A) 2 3 2.5 Price (P) 10 10 10 Sales (S) 236 284 260 True demand S � 120 � 2P � 8A � 0.04I Estimated demand S � 140 � 48A
Table 4.1 An Example of the Omitted-Variables Problem
The true demand curve of the company in this example is Sales � 120 � 2P � 8A � 0.04I. The data for 2006 to 2008 are presented in the table. If the analyst omits income and uses statistical techniques to estimate a relation between advertising and sales, the analyst will obtain the following equation: Sales � 140 � 48A. The model predicts sales perfectly (based on the data in the table). The estimated equation, however, significantly overstates the influence of advertising. The omitted-variables problem is present whenever important variables are left out of the analysis that are correlated with the explanatory variables that are included in the analysis.
18The manager does not have to worry about controlling for price, since it was constant over the period ($10). 19The problem does not always result in overstated coefficients on the explanatory variables. Depending on the
nature of the correlation among the explanatory variables, the coefficients can be either overstated or
understated. The estimated coefficient in this example is overstated because advertising and income are
positively correlated.
Chapter 4 Demand 145
Identification Problem Another potentially important problem that can confront Brendis is the identification problem. This problem also can be illustrated by example. Suppose the marketing manager has collected data on past prices and sales for a given industry with the aim of estimating an industry demand curve. In the past three years, the following sales and price combinations have been observed: (10, $10), (12, $8), and (14, $6). Is it valid for Brendis to connect these three points as an estimate of the demand curve? Because of the identification problem, the answer is generally no.
Each data combination reflects the intersection of the demand curve and supply curve for the industry for each year. If the demand curve has shifted over the three years due to changes in factors such as personal income, the points come from three different demand curves. Connecting the points does not provide an estimate of the current demand curve. In fact, if supply considerations have been stable while de- mand has shifted, it will trace out the industry’s supply curve. Suppose in our exam- ple that both the demand and supply curves have shifted in each year. As shown in Figure 4.7, the resulting combinations of price and quantity are observed equilibrium points, given the conditions during the relevant time periods. Connecting these points provides a poor estimate of the current demand curve D3.
Sometimes, Brendis will not have enough information to solve the identification problem and is better off using consumer interviews or market experiments to esti- mate demand. Other times, she has enough information to identify the demand func- tion (she needs to be able to specify factors that influence demand, but not supply, and vice versa). One special case in which Brendis does not have to worry about the identification problem is when the demand curve is stable. Suppose the demand curve did not shift over the three years and all the different sales-price combinations were caused by changes in supply. In this case, she can obtain a reasonable estimate of the demand curve simply by connecting the observed sales-price combinations.
Q1
P1
S1
D1
P2
S2
D2
P3
$
Q Q2 Q3
S3
D3
Estimated demand
P ri ce
( in
d o lla
rs )
Quantity
Figure 4.7 An Example of the Identification Problem
An analyst has collected data on past prices and sales for her firm’s industry. The demand and supply curves have shifted over the three years. Connecting the three price-quantity points provides a poor estimate of the current industry demand curve (labeled D3 in the graph). The three points are equilibrium points, given all conditions that affect the demand and supply of the product at each point in time. They are not three points along the same demand (or supply) curve.
146 Part 2 Managerial Economics
Implications
We have discussed some of the difficulties that managers face in trying to estimate the demand for their product. These problems can be difficult to solve. Nonetheless, estimates of demand play a critical role in decision making—especially the pricing decision. Successful managers address these problems the best they can, given im- perfect knowledge and limited resources.
ANALYZING MANAGERIAL DECISIONS: Personal Video Recorders
Personal video recorders (PVRs) are digital video
recorders used to record and replay television
programs received from cable, satellite, or local
broadcasts. But unlike VCRs, which they replace,
PVRs offer many more functions, notably the abil-
ity to record up to 3,000 hours of programs and
easy programming. A PVR consists of an internal
hard disk and microprocessor. After the owner in-
stalls the hardware, the PVR downloads all upcom-
ing TV schedules to the hardware via a phone or
cable connection. Users merely enter the name of
the show(s) they want recorded and the system
finds the time and channel of the show and
automatically records it. Users must subscribe to a
cable or satellite system if they wish to record
programs off these channels.
Besides ease of programming and much larger
recording capacity than videotape, PVRs allow the
user to watch a prerecorded show while the unit is
recording up to five new programs, pause watching
live programs (e.g., if the phone rings) and then re-
sume watching the rest of the live broadcast, view
instant replays and slow motion of live programs,
and skip commercials. In effect, PVRs, like older
VCRs, allow viewers to control when they watch
broadcast programs (called “time shifting”). How-
ever, PVRs provide much sharper pictures and are
much simpler to operate than VCRs, and PVRs
allow the user to download the television schedule
for the next week.
Two companies that begin selling PVRs and
subscription services were: TiVo and ReplayTV.
Both firms started in 1997. As of 2013 TiVo had
about one million subscribers and ReplayTV had
been purchased by DirectTV. Companies are devel-
oping new technologies that make it even easier for
users to “snip” commercials.
Cable companies now offer a combined cable
box and PVR in one unit for a small additional
monthly charge. This further simplifies setup and
operation, and the user gets a single bill.
1. Discuss how PVRs will affect the demand
from advertisers?
2. Suppose you are in charge of setting the price
for commercial advertisements shown during
Enemies, a top network television show. There is a 60-minute slot for the show. However, the
running time for the show itself is only 30 min-
utes. The rest of the time can be sold to other
companies to advertise their products or do-
nated for public service announcements. De-
mand for advertising is given by:
Qd � 30 � 0.0002P � 26V
where Qd � quantity demanded for advertising on the show (minutes), P � the price per minute that you charge for advertising, and V is the number of viewers expected to watch the
advertisements (in millions).
a. All your costs are fixed and your goal is to maximize the total revenue received from
selling advertising. Suppose that the ex-
pected number of viewers is one million
people. What price should you charge?
How many minutes of advertising will you
sell? What is total revenue?
b. Suppose price is held constant at the value from part (a). What will happen to the quantity demanded if due to PVRs the num-
ber of expected viewers falls to 0.5 million?
Calculate the “viewer elasticity” based on
the two points. Explain in words what this
value means.
Chapter 4 Demand 147
3. As more viewers begin using PVRs, what hap-
pens to the revenues of the major networks
(CBS, NBC, ABC, and FOX)?
4. Discuss the long-run effects if a significant
proportion of the viewers begin adopting these
“advertising snipping” systems.
5. What advice would you give the major
commercial networks and producers of
programming for these networks as more
consumers adopt PVRs?
Source: J. Gudmundsen (2002), “Video Gizmos Change the Rules,” Democrat and Chronicle (August), 5E and 8E; B. Fisher (2003), “TiVo and Replay TV Have Features to Satisfy Any TV Junkie,” Detroit News (June 24); R. Reilly (2003), “Great Invention Period,” Sports Illustrated (December 22).
Summary Understanding product demand is critical for many managerial decisions such as pricing, setting production levels, undertaking capital investment, and establishing an advertising budget. This chapter provides a basic analysis of demand.
A demand function is a mathematical representation of the relations among the quantity demanded of a product over a specified time period and the various factors that influence this quantity. We focus on three independent variables in the demand function: the price of the product, the prices of related products, and customers’ incomes.
A demand curve for a product displays how many units will be purchased over a given period at each price holding all other factors fixed. Movements along a de- mand curve reflect changes in price and are called changes in the quantity de- manded. Movements of the entire demand curve are caused by other factors, such as changes in income, and are referred to as changes in demand.
Demand curves generally slope downward to the right: Quantity demanded varies inversely with price. This relation often is referred to as the law of demand. Demand curves vary in their sensitivities of the quantity demanded to price. Price elasticity is defined as the percentage change in quantity demanded from a percent- age change in price (expressed as a positive number). The price elasticity tends to be high when there are close substitutes for the product and when the good repre- sents a significant expenditure for the consumer. Demand tends to be more elastic over the long run than over the short run. How total revenue from a product changes with price depends on the price elasticity. A small price increase results in an in- crease in expenditures when demand is inelastic and a decrease in expenditures when demand is elastic. Total expenditures remain unchanged when the demand elasticity is unitary.
An important concept in economics is marginal revenue, which is defined as the change in total revenue given a one-unit change in quantity. Marginal revenue for a linear demand curve is given by the line with the same intercept as the demand curve but with twice the negative slope. Total revenue increases with quantity when marginal revenue is positive and decreases with quantity when marginal revenue is negative.
The price of related products can affect the demand for a product. Goods that compete with each other are referred to as substitutes. Products that tend to be con- sumed together are complements. One frequently used measure of substitution be- tween two products is the cross elasticity of demand. The cross elasticity is positive for substitutes and negative for complements.
148 Part 2 Managerial Economics
Another factor that can affect the demand for a product is the income of potential buyers. The sensitivity of demand to income is measured by the income elasticity. The income elasticity is positive for normal goods, and negative for inferior goods.
Demand curves can be defined for individual firms or entire industries. The price elasticities for individual firms within an industry are generally higher than for the industry as a whole. Cross elasticities can be helpful in defining the appropriate industry.
For some products, demand increases with the number of users. For example, telephones are not very useful unless there is a network of users. Products where these network concerns are important often have relatively elastic demands. When price is lowered, there is both a standard price effect and a network effect.
The standard economic analysis of demand takes the attributes of the product as given. Information about consumer demand, however, is also important in the initial design of products. In Chapters 11–23 of this book, we provide important insights into how to design the firm’s organizational architecture to help ensure that this type of information is incorporated in the decision making process.
Managers use three basic approaches to estimate demand: interviews, price exper- imentation, and statistical analysis. All three approaches can suffer from potentially serious problems. Managers have to do the best they can given imperfect information and limited resources. Knowledge of the potential pitfalls can make managers more intelligent producers and users of demand estimates.
G. Stigler (1987), The Theory of Price (Macmillan: New York), Chapter 3.
4–1. Suppose Product A has the demand function QA � 10 � 5PA � 2PB � 0.01I. The initial values of the variables are QA � 15, PA � $4, PB � $2.5 and I � $2,000. a. When PA moves to $3.4, keeping other variables at their initial values, QA becomes 18.
What is the corresponding own-price arc elasticity of demand?
b. If income, I, increases to $2,250 per period with all other variables held at their ini- tial values, QA becomes 17.5. What is the corresponding income arc elasticity of de- mand?
c. If PB increases to $3 with all other variables held at their initial values, QA becomes 16. What is the corresponding cross-price arc elasticity of demand?
d. Is Product A an inferior or normal good? Are Product A and Product B substitutes or complements? Explain.
e. Is the firm charging the revenue maximizing price for Product A at the initial values? Explain.
f. Compute the MR at the initial values.
4–2. Suppose your firm faces a demand curve of P � 90 � .30Q. Find the revenue maximizing output and price. Calculate the total revenue. Is this outcome on the elastic, inelastic, or uni-
tary elastic part of the demand curve? Is this price the optimal price for your firm to charge?
Display this choice graphically (showing the demand and marginal revenue curves).
4–3. The BJC Company has the following demand function:
Q � 300 � 30(price) � 0.01(income)
Currently, price is $5 and income is $20,000.
a. Calculate the point elasticities for price and income. b. Is the product a normal or an inferior good?
Self-Evaluation Problems
Suggested Reading
Chapter 4 Demand 149
4–4. Last year, Americans bought 5,000 Ferraris. The average retail price of a Ferrari was $100,000. Statistical studies have shown that the price elasticity of demand is 0.4. Assume
the demand curve is linear. Estimate it using the above information.
a. Is demand elastic or inelastic? b. What will happen to revenue if the company raises its price?
Solutions to Self-Evaluation Problems
4–1. a.
b.
c.
d. Product A is normal because an increase in income leads to an increase in demand for the product. Products A and B are substitutes because the cross-price elasticity is positive.
Consumers substitute away from B and purchase more A when the price of B increases.
e. No, the firm is not charging the revenue maximizing price for Product A. Revenue maxi- mization occurs at the price/quantity where MR � 0 and the corresponding own-price elasticity is one. But here we see that � 1.12 � 1. Therefore, the current price is higher than the revenue maximizing price, while the current quantity is lower than the
revenue maximizing quantity.
f. Start with the original demand function, QA � 10 � 5PA � 2PB � 0.01I and insert the initial values for PB and I. Solve for PA. This produces the demand curve for Product A: PA � 7 � .2Q. The MR function has the same intercept at the demand curve, but twice the negative slope: MR � 7 � .4Q. At the initial quantity of 15, MR � $1. Producing an additional unit increases revenue by $1.
4–2. The demand curve is given by P � 90 � .30Q. The marginal revenue curve is MR � 90 � .60Q. Revenue maximization occurs where MR � 0. Thus the revenue maximizing quan- tity, Q*, is
90 � .60Q* � 0 Q* � 150.
The revenue maximizing price is found by inserting Q* into the demand function:
P* � 90 � (.3 � 150) � $45.
Revenue maximization occurs at the midpoint of the demand curve, where the price elastic-
ity is equal to one (unitary elasticity). The goal of the firm is to maximize profits, not rev-
enue. Thus the firm is not at the optimal price unless the marginal cost of production � $0. Graphically the analysis is pictured as follows:
Demand
Q
MR
$45
15
$90
$/unit
Unitary price elasticity
hPA QA
hPB QA
=
(16 - 15)
(3 - 2.5) *
2.75 15.5
=
1 0.5
*
2.75 15.5
= 0.354
hI QA
=
(17.5 - 15)
(2250 - 2000) *
2125 16.25
=
2.5 250
*
2125 16.25
= 1.307
hPA QA
= Absolute Value - (18 - 15)
(3.4 - 4) *
3.7 16.5
=
3 0.6
*
3.7 16.5
= 1.12
150 Part 2 Managerial Economics
4–3. a. The current quantity demanded is 350. Thus, the price elasticity is 30(5�350) � .429. The income elasticity is .01($20,000�350) � .571.
b. The product is a normal good (income elasticity is positive).
4–4. If the demand curve is linear, it must take the form P � a � bQ. To estimate a and b we use the information provided. The elasticity of demand can be expressed as:
� � abs [(�1�b) � (P�Q )]
We are told that at P � 100,000 and Q � 5,000, the elasticity of demand equals 0.4. Substi- tuting the known values, solve for b :
0.4 � (1�b) � (100,000�5,000) b � 50
100,000 � a � 50 � 5,000 a � 350,000
4–1. What is the difference between a demand function and a demand curve?
4–2. How will each of the following affect the position of the demand curve for DVD players? a. An increase in the price of DVD movies. b. A decrease in the price of DVD players. c. An increase in per capita income. d. A decrease in the price of movie tickets.
4–3. If the demand for a product is inelastic, what will happen to total revenue if price is increased? Explain.
4–4. What are the signs of cross elasticities for substitute products? Explain.
4–5. Distinguish between normal and inferior goods.
4–6. Is it true that a normal good must have an income elasticity that is more than one? Explain.
4–7. Suppose that the price of Product A falls from $20 to $15. In response, the quantity demanded of A increases from 100 to 120 units. The quantity demanded for Product B increases from
200 to 300. Calculate the arc cross elasticity between Product B and Product A. Is B a substi-
tute or complement for A? Explain. Does Product A follow the “law of demand”? Explain.
4–8. How can cross elasticities be used to help define the relevant firms in an industry?
4–9. Suppose the price of heating oil increases significantly. Discuss the likely short-run and long-run effects.
4–10. The Alexander Machine Tool Company faces a linear demand curve. Currently, it is selling at a price and quantity where its demand elasticity is 1.5. Consultants have suggested that
the company expand output because it is facing an elastic demand curve. Do you agree with
this recommendation?
4–11. For three years in a row, income among consumers has increased. Alexander Machine Tool has had sales increases in each of these three years. Does Alexander Machine Tool
produce inferior or normal goods? Forecasts predict that income will continue to rise in
the future. Should Alexander Machine Tool anticipate that demand for its products will
continue to rise? Explain.
4–12. The cross elasticity between Product A and Product B is 10. Do you think that Product A is likely to face an elastic or inelastic demand curve? Explain.
4–13. Vijay Bhattacharya is interested in estimating the industry demand curve for a particular product. He has gathered data on historical prices and quantities sold in the industry. He
knows that the industry supply curve has been stable over the entire period. He is consider-
ing estimating a regression between price and quantity and using the result as an estimate of
the demand curve. Do you think this technique will result in a good estimate of the demand
curve? Explain.
Review Questions
Chapter 4 Demand 151
4–14. Maria Tejada, a civil engineer, uses data on population trends to forecast the use of a partic- ular highway. Her forecasts indicate severe road congestion by the year 2010. She suggests
building a new road. Comment on this approach.
4–15. Alexander Machine Tool faces the demand curve P � $70 � 0.001Q. What price and quan- tity maximize total revenue? What is the price elasticity at this point?
4–16. Studies indicate that the income elasticity of demand for servants in the United States ex- ceeds 1. Nevertheless, the number of servants has been decreasing during the last 75 years,
while incomes have risen significantly. How can these facts be reconciled?
4–17. Prior to a price increase, the price and quantity demanded for a product were $10 and 100, respectively. After the price increase, they were $12 and 90.
a. Calculate the arc elasticity of demand. b. Is the demand elastic or inelastic over this region? c. What happened to total revenue?
4–18. Define marginal revenue. Explain why marginal revenue is less than price when demand curves slope downward.
4–19. In 1991, Rochester, New York, had a serious ice storm. Electric power was out in houses for days. The demand for power generators increased dramatically. Yet the local merchants did
not increase their prices, even though they could have sold the units for substantially higher
prices. Why do you think the merchants adopted this policy?
4–20. Seven teenagers, four boys and three girls, were given $200 each to go on a shopping spree. An advertising agency, which specializes in youth markets, gave the teens the money. An
account executive accompanied the teens while they were shopping. The agency wanted to
learn not only what they bought, but also what they talked about to see what was on their
minds. “It’s not so much to stay in tune with trends, because trends are elusive. It’s more
what’s really happening with teens and what’s important to them.”20
a. Discuss the trade-offs between sample size (7 teens), cost, and reliability of what is learned from this experiment.
b. An agent accompanied the teens while they were shopping. Why didn’t the ad agency avoid this expense and just look at what the teens bought?
4–21. Southwest Airlines estimates the short-run price elasticity of business air travel to be 2 and the long-run elasticity to be 5. Is ticket demand more elastic in the short run or long run?
Does this seem reasonable? Explain.
4–22. Gasoline prices increased substantially in 2004 and 2005. What adjustments did people make to minimize the long-term effects of this price increase?
4–23. Assume that demand for product A can be expressed as QA � 500 � 5PA � 3PB and de- mand for product B can be expressed as QB � 300 � 2PB � PA. Currently, market prices and quantities for these goods are PA � 5, PB � 2,QA � 481, and QB � 301. a. Suppose the price of product B increases to 3. What happens to the quantity demanded
of both products?
b. Calculate the arc cross-elasticity between product A and product B using prices for product B of 2 and 3.
c. Are these goods substitutes or complements?
4–24. The Zenvox Television Company faces a demand function for its products that can be expressed as Q � 4,000 � P � 0.5I, where Q is the number of televisions, P is the price per television, and I is average monthly income. Average monthly income is currently equal to $2,000. Answer the following questions.
a. Graph the demand curve (sometimes called the “inverse” demand curve) faced by Zenvox at the current income level. Be sure to label this and all graphs you draw carefully. On the
same graph, depict marginal revenue. At what price and quantity is Zenvox’s total revenue
maximized? What is the marginal revenue at this point? Show the calculation.
20“Teens Track Retail Trends for Ad Agency (1999),” Democrat and Chronicle (September 5), 1E.
152 Part 2 Managerial Economics
b. What is the price elasticity of Zenvox’s demand function at the price and quantity de- rived in part (a)? Explain what this value means in words.
c. Why might Zenvox choose to produce at a price and quantity different than that derived in part (a)?
4–25. According to an article in Forbes (March 2001) teen cigarette smoking declined signifi- cantly between 1975 and 2000. The most dramatic decline occurred in the years
1975–1981. Since then teen smoking has increased in some years and declined in others.
Between 1975 and 1981 there was a slight decrease in the price of cigarettes. Thus the dra-
matic decline in smoking is not attributable to an increase in cigarette prices. One theory is
that the significant increase in gasoline prices over this period motivated many teens not to
smoke.
a. Discuss how a rise in gasoline prices might affect the demand for cigarettes among teens.
b. Suppose there are two goods in the world, cigarettes and gasoline. Draw a figure that shows how an increase in gasoline prices can result in a decline in both gasoline and
cigarette consumption. Use the standard consumer behavior graph with budget lines
and indifference curves. Be sure to label your figure appropriately.
c. In the late 1990s the price of cigarettes increased from $2.50 per pack to $3.25 per pack. In one community during this time period, the number of packs of cigarettes consumed
by teenagers fell from 10,000 to 9,000. Assume that everything except cigarette prices
remained the same. Calculate the arc price elasticity among teens between these price
points.
d. Calculate the total expenditures on cigarettes by the teens in part (c) both before and after the price increase. Did total revenue increase or fall? Discuss how this answer is
implied by the arc elasticity that you calculated in part (c).
4–26. In an article appearing in the Dow Jones News Service on February 5, 2004, the agency cites Saudi Arabia’s concern about the overproduction of oil by the OPEC cartel.
Assume the current daily demand for OPEC’s oil is given by the following equation:
P � 50 � 0.001Q
where P is the price per barrel (ppb) and Q is the quantity of barrels sold daily (in thou- sands). Moreover, suppose the marginal cost of producing a barrel is constant at zero. a. Would it surprise you to learn that OPEC’s declared objective is to sell 25 million bar-
rels a day for an average price of $25 per barrel? Why or why not? Explain. You may
use a graph to support your argument.
b. Assume that after OPEC’s meeting this week, the new demand for OPEC oil will be given by P � 40 � .001Q. Would OPEC’s stated objective (25 million barrels at an overall price of $25) be attainable after this change? Explain. Assume OPEC ignores the
demand shift. What’s the maximum price per barrel they can charge if they decide to
keep producing 25 million barrels per day? What is the profit in this case?
c. Now suppose that OPEC recognizes that demand has changed (as in [b]) and wants to maximize profits. What is the daily quantity they should supply? At what price? What
is the profit in this case? What is the price elasticity of demand at this price/quantity
combination? Explain.
4–27. As a result of strikes in Canada the world price of nickel rose by 20 percent in December. Over the same period, the quantity demanded of nickel decreased from 10,000,000 to
8,500,000 pounds worldwide. The world price of nickel was 70 cents per pound before
the strikes.
a. Show graphically the effect of Canadian strikes on the market for nickel. b. Given the information above, what’s the price elasticity of the world demand for nickel
over the relevant price range?
c. Did the total expenditure for nickel increase, decrease, or remain constant after the strikes? How is this consistent with your answers to parts (a) and (b)? Explain clearly and concisely.
Chapter 4 Demand 153
4–28. Assume the demand curve for gasoline is given by the equation
P � 10 � 0.0005Q,
where P is the price per gallon and Q is the quantity of gasoline in gallons. Assume that the only supplier of gasoline in the region is General Gasoline Co. and that the marginal cost of
production is constant at zero.
a. If the company is currently charging $4 a gallon, is it maximizing profit? If so, prove it. If not, find out the price that maximizes its profit, and compare the profits at the
two prices.
b. Discuss the likely effect of the introduction of a fuel-efficient car in the region; that is, what would happen to the equilibrium quantity. Show the changes on a graph that
displays (you don’t need to show actual numbers) General Gasoline’s pricing solution
and explain.
4–29. The accompanying chart presents data on the price of fuel oil, the quantity demanded of fuel oil, and the quantity demanded for insulation.
Fuel Oil Insulation
Quantity Demanded Quantity Demanded Price per Gallon (millions of gallons) (millions of tons)
$3 100 30 $5 90 35 $7 60 40
a. Calculate the price elasticity (arc elasticity) of demand for fuel oil as its price rises from 30 to 50 cents; from 50 to 70 cents. Calculate the change in total revenue in
the two cases. Explain how the changes in revenue relate to your estimated elasticities.
b. Calculate the arc cross elasticity of demand for insulation as the price of fuel oil rises from 50 to 70 cents. Are fuel oil and insulation substitutes or complements?
Explain.
4–30. Japan has 4,350 miles of expressway—all toll roads. In fact, the tolls are so high that many drivers avoid using expressways. A typical 3-hour expressway trip can cost $47. A
new $12 billion bridge over Tokyo Bay that takes 10 minutes and costs $25 rarely is busy.
One driver prefers snaking along Tokyo’s city streets for hours to save $32 in tolls.21
Assume that the daily demand curve for a particular stretch of expressway is:
P � 800 yen � .16Q
a. At what price-quantity point does this demand curve have a price elasticity of one? b. Assume the government wishes to maximize its revenues from the expressway, what
price should it set? And how much revenue does it generate at this price?
c. Suppose that traffic engineers have determined that the efficient utilization of this par- ticular toll road is 4,000 cars per day. This traffic level represents an optimum tradeoff
between congestion (with its associated reduction in speeds and increase in accidents)
between expressways and surface roads. If 4,000 cars per day is the socially efficient
utilization of the toll road, what price should be set on the toll road? And how much
revenue is collected by the government?
d. Which price, the one in part (b), or the one in part (a) would you expect the government to set?
21J. Singer (2003), “Lonesome Highways: In Japan, Big Tolls Drive Cars Away,” The Wall Street Journal (September 15), A1 and A15.
154 Part 2 Managerial Economics
Appendix: In the chapter, we presented formulas for arc elasticities that estimate elasticities Demand22 between two points on the demand curve. This appendix shows how to calculate elas-
ticities at single points on the demand curve. It also derives the equation for marginal revenue for a linear demand curve and discusses a special (log-linear) demand function.
Point Elasticities Elasticities measure the percentage change in quantity demanded for a percentage change in some other variable. There are several ways to express the formula for an elasticity. One way, using price elasticity as an example, follows:
� � �(�Q�Q )�(�P�P ) (4.12) � �(�Q��P ) � (P�Q )
By definition, as the change in P goes to zero, the limit of the first term (�Q��P ) is the partial derivative of Q with respect to P. At a particular point on the demand curve, the elasticity of demand for small changes in P is given by
� � �( Q� P ) � (P�Q ) (4.13)
As an example, consider the demand function for PTC theater tickets:
Q � 117 � 6.6P � 1.66PS � 3.3PR � 0.0066I (4.14)
The point elasticity at the current price-quantity combination of $30 and 200 tickets is
� � �(�6.6) � (30�200) � 1 (4.15)
Recall that this is the value that we derived graphically in the text (see Figure 4.5). Other point elasticities—for example, point cross elasticities—can be calculated
in a similar fashion. Simply substitute the appropriate variable (e.g., the price of another product) for P in Equation (4.13).
Marginal Revenue for Linear Demand Curves Marginal Revenue (MR) is the change in total revenue for an additional unit of quan- tity. As the change in quantity becomes very small, the limit of this definition is the partial derivative of total revenue with respect to Q.
Linear demand curves take the following form:
P � a � bQ (4.16)
Thus, total revenue, P � Q can be written as:
TR � (a � bQ ) � Q (4.17) � aQ � bQ 2
Marginal revenue is
MR � TR � Q � a � 2bQ (4.18)
22This appendix requires elementary knowledge of calculus.
Chapter 4 Demand 155
This formula is a line that has the same intercept as the demand curve, but with twice the negative slope.
Marginal Revenue and Demand Elasticity In this section, we derive the relation between marginal revenue and demand elastic- ity. This relation is useful in a number of contexts. For example, it underlies a for- mula that we use in Chapter 7 to analyze how a firm’s optimal price markup over cost relates to the product’s demand elasticity.
By definition:
TR � PQ (4.19) MR � TR� Q � ( � Q � Q ) � P
Multiply the quantity in parentheses by P�P :
MR � ( P� Q � Q ) � (P�P ) � P (4.20) � ( P� Q � Q�P ) � P � P � P � [1 � 1��]
Equation (4.20) indicates that marginal revenue is equal to price when demand is perfectly elastic. In this case, the firm can sell one more unit at the market price with- out having to lower the price. MR falls as the elasticity decreases and is negative when demand is inelastic (� 1).
Log-Linear Demand Functions The following demand function is frequently used in empirical demand estimation:
Q � �P �I � (4.21)
where Q is the quantity demanded P is price I is income
(Other variables such as advertising and the price of other goods are commonly in- cluded as other explanatory variables.) An important property of this demand func- tion is that the price and income elasticities are constant (they do not vary along the demand function) and are equal to �� and �, respectively. In particular:
� � �( Q� P ) � (P�Q ) (4.22) � �(��P ��1I � ) � (P��P �I �) � ��
Similarly, � is the income elasticity. Taking the natural logarithm of the demand function in Equation (4.21) yields
lnQ � ln� � �lnP � �lnI (4.23)
This equation is linear in the logarithms; it thus can be estimated by standard regres- sion analysis using data on Q, P, and I. The estimated coefficients � and � are estimates of the price and income elasticities. Other types of elasticities—for example, cross elasticities—can be estimated by including other variables in the demand equation.
chapter
5 C H A P T E R O U T L I N E
Production Functions
Returns to Scale
Returns to a Factor
Choice of Inputs
Production Isoquants
Isocost Lines
Cost Minimization
Changes in Input Prices
Costs
Cost Curves
Short Run versus Long Run
Minimum Efficient Scale
Learning Curves
Economies of Scope
Profit Maximization
Factor Demand Curves
Cost Estimation
Summary
Appendix: The Factor- Balance Equation
T he global demand for steel has increased in recent years due in part to major construction projects in countries such as China and India. Construction crews were particularly busy in China on projects re- lated to the 2008 Beijing Olympics, the 2010 Shanghai World Ex-
position, and new housing. While the world production of steel also has in- creased, the net result has been an increase in steel prices from their historic levels. In the early 1990s, steel sold for under $100 per ton. In July 2014, the price was $740 per ton. This more than sevenfold increase in the price of steel far exceeds the rate of inflation, which was about 70 percent over the same period. Steel prices not only increased over this period but also dis- played high volatility. In spring 2002 the price was as low as $222, but by fall 2004 it had increased to above $700. It subsequently retreated to under $500 in late 2005, but by mid-2008 exceeded $1,200.1
Automobile manufacturers are a major user of steel. High steel prices provide strong incentives to these companies to find ways to mitigate the price increase, for example, by substituting away from steel toward rela- tively less expensive production materials. Consider their actions during the 1990s when steel prices began their recent assent. In 1994, domestic steel
Production and Cost
1Steel prices are from steelbenchmarker.com.
L E A R N I N G O B J E C T I V E S
1. Explain what is meant by a production function. 2. Distinguish between returns to scale and returns to a factor. 3. Create a graphical analysis of the cost-minimizing input mix and explain how it
is affected by changes in relative prices of inputs.
4. Define and describe the relationship among total, marginal, and average costs. 5. Describe the connection between production and cost functions. 6. Distinguish between short- and long-run costs curves. 7. Define fixed and variable costs and their role in decision making. 8. Explain long-run costs, sources of economies and diseconomies of scale and
scope, and the notion of minimum efficient scale.
9. Explain why MR � MC at the profit maximizing output. 10. Understand how many units of a factor (such as labor) a firm should purchase
at different factor prices.
Chapter 5 Production and Cost 157
prices increased as the U.S. economy recovered from a recession.2 Indeed, the steel market was the strongest it had been in 20 years: Specifically, steel prices had risen from below $90 to over $135 per ton between 1992 and 1994. After significant price increases earlier in the year, domestic steel companies were planning to increase sheet-steel prices by another 10 percent at year’s end. In the tight electrogalvanized markets, price increases as high as 20 percent were expected. (In fact, in 1995, prices exceeded $142 per ton.)
To counter the effects of the increase in domestic steel prices, U.S. auto compa- nies actively pursued new overseas suppliers. For instance, in July 1994, General Motors invited bids for sheet steel from foreign companies such as Sidmar, Solldac, Thyssen, and Klockner. The increases in steel prices affected both companies’ pric- ing and output decisions. The increases in steel prices also placed pressure on U.S. automakers to use other raw materials in the production process. For example, auto companies increased their use of aluminum in engines, transmissions, body com- ponents, heating and cooling systems, and suspension systems in 1995.3
(Aluminum prices had been relatively stable; they were $.534 per pound at the be- ginning of 1992 and $.533 in January 1994.) Potential applications focused on re- placing cast iron or steel with aluminum. In addition, auto companies increased re- search on new ways to use plastics, magnesium, and recyclable materials in their production process.
This example raises a number of questions that are of interest to managers. First, how do firms choose among substitutable inputs in the production process? How does the optimal input mix change with changes in the input prices? How do changes in input prices affect the ultimate cost of production and the output choices of firms? In this chapter we address these and related questions. Major topics in- clude production functions, choice of inputs, costs, profit maximization, cost esti- mation, and factor demand curves. In the appendix, we derive the factor-balance equation.
Production Functions A production function is a descriptive relation that links inputs with output. It speci- fies the maximum feasible output that can be produced for given amounts of inputs. Production functions are determined by the available technology. Production func- tions can be expressed mathematically. For instance, given current technology, an automobile supplier is able to transform inputs like steel, aluminum, plastics, and labor into finished auto parts. In its most general form, the production function is ex- pressed as
Q � f (x1, x2, . . . xn) (5.1)
where Q is the quantity produced and x1, x2, . . . xn are the various inputs used in the production process.
2Details of this example are from “General Motors Eyes Imports to Counter Price Increases,” Metal Bulletin (July 11, 1994), 21.
3A. Wrigley (1994), “Automotive Aluminum Use Climbing in 1995’s Models: Automotive Applications Will
Use Some 120 Million Lbs. in 1995,” American Metal Market (August 9), 1.
158 Part 2 Managerial Economics
To simplify the exposition, suppose that the auto part in this example is pro- duced from just two inputs—steel and aluminum. An example of a specific produc- tion function4 in this context is
Q � S 1�2 A1�2 (5.2)
where S is pounds of steel, A is pounds of aluminum, and Q is the number of auto parts produced.
With this production function, 100 pounds of steel and 100 pounds of aluminum will produce 100 auto parts over the relevant time period, 400 pounds of steel and 100 pounds of aluminum will produce 200 auto parts, and so on.5
Returns to Scale
The term returns to scale refers to the relation between output and the proportional variation of all inputs taken together. With constant returns to scale, a 1 percent change in all inputs results in a 1 percent change in output. For example, Equation (5.2) presents a production function with constant returns to scale. If the firm uses 100 pounds of each input, it produces 100 auto parts. If the firm increases both in- puts by 1 percent to 101 pounds, it produces 101 auto parts.6
With increasing returns to scale, a 1 percent change in all inputs results in a greater than 1 percent change in output. An example of such a production function is
Q � S A (5.3)
Here, 100 pounds of steel and 100 pounds of aluminum produce 10,000 auto parts, while 101 pounds of steel and aluminum produce 10,201 auto parts (a 2 percent in- crease in output). Firms often experience increasing returns to scale over at least some range of output. One major reason is that a firm operating on a larger scale can engage in more extensive specialization. For instance, if an automobile company has only three employees and three machines, each employee and each machine has to
M A N A G E R I A L A P P L I C AT I O N S
Increasing Returns to Scale Motivates Amazon to Invest in Large Warehouses The Law of Increased Dimensions (the “Container Principle”) implies that the doubling of the height and width of a container leads to more than a proportionate increase in cubic capacity (volume). The corresponding increasing returns
to scale have led Amazon.com to invest in huge warehouses that are capable of storing hundreds of thousands of items.
As of 2014, Amazon owned or leased over 84 million square feet of space for housing its fulfillment and data centers.
Its largest fulfillment centers are over 1.2 million square feet in size. These large centers are located near major
airports, which are used in the shipping of orders. The resulting cost efficiencies deriving from the size and location of
these centers have contributed to Amazon’s performance.
Source: Amazon.com (2014), Form 10-K for Fiscal Year Ended December 31, 2013 (January 31)
4This production function is an example of a Cobb-Douglas production function, which takes the general
form Q � �S �A�. Cobb-Douglas production functions are used frequently in empirical estimation. Not all firms, however, have production processes that are well described by this particular type of production
function. 51001�2 � 1001�2 � 10 � 10 � 100, and 4001�2 � 1001�2 � 20 � 10 � 200. 6[(100 � 1.01)1�2] � [(100 � 1.01)1�2] � 101.
perform a myriad of tasks for the company to produce automobiles. Given the broad array of tasks that each worker and machine has to perform, efficiency is likely to be low. In contrast, a large firm employing thousands of workers and machines can en- gage in much greater specialization. (As noted in Chapter 3, specialization often pro- duces efficiency gains.)
With decreasing returns to scale, a 1 percent change in all inputs results in a less than 1 percent change in output. An example is
Q � S 1�3 A1�3 (5.4)
The likelihood that a firm will choose to operate where it experiences decreasing re- turns to scale is open to debate. Some economists argue that firms should seldom dis- play decreasing returns to scale. If a facility of a given size can produce a given out- put, why can’t the firm simply replicate that facility and produce twice the output with twice the inputs? Indeed, most empirical studies on the subject suggest that the typical firm initially experiences increasing returns to scale, followed by constant re- turns to scale over a quite broad range of output. On the other hand, several empiri- cal studies indicate that some firms probably do experience decreasing returns to scale.7 Also, casual observation suggests that some larger firms suffer from ineffi- ciencies to a greater extent than do smaller firms—for example, coordination and control problems become more severe as a firm becomes larger.
In our examples, the returns to scale are the same over all ranges of output. For instance, Equation (5.2) always displays constant returns to scale, while Equation (5.4) always displays decreasing returns. Most production functions vary in returns to scale over the range of output. Most frequently, production functions have in- creasing returns to scale when output is relatively low, followed by constant returns to scale as output continues to increase, and possibly decreasing returns to scale when output is high. Other combinations are possible.
Returns to a Factor
Returns to a factor refers to the relation between output and the variation in a single input, holding other inputs fixed. Returns to a factor can be expressed as total, mar- ginal, or average quantities. The total product of an input is the schedule of output obtained as that input increases, holding other inputs fixed. The marginal product of an input is the change in total output associated with a one-unit change in the input, holding other inputs fixed. Finally, the average product is the total product divided by the number of units of the input employed.
To illustrate these concepts, consider the production function in Equation (5.2): Q � S 1�2A1�2. Table 5.1 presents the total, marginal, and average product of S, holding A fixed at 9.8 For this production function, total product increases as S increases; marginal product, however, declines. This means that although total product increases with S, it does so at a decreasing rate. Average product also decreases over the entire range.
7For example, E. Berndt, A. Friedlaender, and J. Chiang (1990), “Interdependent Pricing and Markup
Behavior: An Empirical Analysis of GM, Ford, and Chrysler,” working paper, National Bureau of Economic
Research, Cambridge, MA. 8The production function assumes that production does not have to take place in discrete units. For instance,
output might be expressed in tons; clearly production in fractions of tons is possible.
Chapter 5 Production and Cost 159
160 Part 2 Managerial Economics
More generally, marginal and average products do not have to decline over the en- tire range of output. Indeed, many production functions display increasing marginal and average products over some ranges. However, most production functions reach a point after which the marginal product of an input declines. This observation often is called the law of diminishing returns (or law of diminishing marginal product), which states that the marginal product of a variable factor eventually will decline as its use is increased. To illustrate this principle, consider the classic example of farm- ing a plot of land. Land is fixed at 1 acre, and no output can be harvested without any workers. If 10 bushels of grain can be produced by one worker, the marginal product of the first unit of labor is 10 bushels. The change in output might be even greater as the firm moves from one to two workers. For instance, two workers might be able to produce 25 bushels of grain by working together and specializing in various tasks. The marginal product of labor is 15 bushels and thus, over this range, marginal
Units Units Total Product Marginal Product Average Product of S of A of S of S of S
1 9 3.00 3.00 3.00 2 9 4.24 1.24 2.12 3 9 5.20 0.96 1.73 4 9 6.00 0.80 1.50 5 9 6.70 0.70 1.34
Table 5.1 Returns to a Factor
This table shows the total, marginal, and average products of steel for the production function Q � S1�2 A1�2. Aluminum is held fixed at 9 units. The total product of S is the total output for each level of S; the marginal product of S is the incremental output from one additional unit of S; and the average product of S is output divided by the total units of S.
M A N A G E R I A L A P P L I C AT I O N S
Studying for an Exam—the Law of Diminishing Returns Your performance on the CPA exam depends on both your effort and aptitude in the subject. Your aptitude is largely a
fixed input (e.g., it is hard to increase your basic IQ). Effort on the other hand is something you can control and vary.
For example, if you are preparing for the CPA exam, you could spend many or few hours reading books and working
problems. The choice is yours. If you exert no effort, you are unlikely to do well on the exam and easily could fail. If
you study, your performance is likely to improve. Initially, as you begin to allocate additional hours to studying for the
exam, your rate of improvement might be quite large. For instance, you might expect to increase your exam score by
20 points if you study one versus no hours. As you continue to spend more time on studying for the exam, your rate of
improvement (marginal product of effort) is likely to decline—you will reach a point of diminishing returns. Indeed at
some point your exam score could decline with additional effort as you become too tired to take the exam—the
marginal product of effort becomes negative. Basic economics says that you should study for an exam up to the point
where the incremental benefits of studying additional time are equal to the incremental costs. The law of diminishing
returns implies that the incremental benefits will eventually become smaller and possibly negative. The incremental
costs of studying an additional hour depend on your opportunity cost of time—for what else could you use the time? It
is unlikely to be optimal for you to spend additional time studying for the CPA exam if that causes you to neglect your
other professional responsibilities.
product is increasing. Eventually, as the firm continues to add more workers, while holding land fixed, output will grow at a slower rate. At some point, total output might actually decline with additional workers because of coordination or conges- tion problems. In this case, the marginal product is negative.
Figure 5.1 illustrates returns to a factor in this common case. The upper panel dis- plays total product, and the lower panel displays marginal and average products. As the use of input S goes from zero to S1, marginal product rises. Over this range total product is convex—total product increases at an increasing rate.9 At S1, diminishing returns set in and the marginal product begins to fall. Between S1 and S2, marginal product is positive and so total product continues to increase. However, it does so at a decreasing rate (the curve is concave). Beyond S2, marginal product is negative, hence total output falls with increases in S. Average product is rising where marginal product is above average product and is falling where marginal product is below
Marginal product
Average product
S1
S
Q/S
Q
Total product
S
Q u a n tit
y o f a u to
p a rt
s Q
u a n tit
y o f a u to
p a rt
s (p
e r
u n it
o f st
e e l)
Quantity of steel
S2
Figure 5.1 Returns to a Factor: A Common Case
This figure illustrates a common pattern for total product, marginal product, and returns to a factor. In the lower panel, marginal product rises, then falls, and eventually becomes negative. When marginal product is rising (between zero and S1), total product increases at an increasing rate (the curve is convex) in the lower panel. When marginal product is falling but positive (between S1 and S2), total product continues to increase but does so at a decreasing rate. Beyond S2, marginal product is negative and total product falls with additional output. Average product is rising where it is below marginal product and is falling where it is above marginal product. Average and marginal products are equal where average product is at a maximum.
9Technical note: The marginal product at a point is equal to the slope of the total product curve at that point
(MP � �TP/�S). Thus, marginal product is decreasing when the total cost curve is concave and increasing when it is convex.
Chapter 5 Production and Cost 161
162 Part 2 Managerial Economics
average product. Marginal product and average product are equal where average product is at its maximum.10 This relation is a general rule.11 The accompanying box on baseball batting averages illustrates the intuition behind this relation.
Choice of Inputs
Production Isoquants
Most production functions allow some substitution among inputs. For example, sup- pose that Alexi Dyachenko is chief operating officer, managing a firm with the pro- duction function Q � S1�2 A1�2, and he wants to produce 100 auto parts. In this case, there are many different combinations of steel and aluminum that will yield 100 auto parts. For instance, 100 auto parts can be produced using 100 pounds of steel and 100 pounds of aluminum, 25 pounds of steel and 400 pounds of aluminum, or 400 pounds of steel and 25 pounds of aluminum. Figure 5.2 displays all the possible combinations of inputs that can be used to produce exactly 100 auto parts. Obvi- ously, 100 auto parts also could be produced with more inputs—points above or to the right of a point on this isoquant—but those points represent inefficient production methods. This curve is called an isoquant (iso, meaning the same, and quant from quantity). An isoquant shows all input combinations that produce the same quantity assuming efficient production. There is a different isoquant for each possible level of production. Figure 5.2 shows the isoquants for 100, 200, and 300 auto parts.
Production functions vary in terms of how easily inputs can be substituted one for another. In some cases, no substitution is possible. Suppose that in order to produce 100 auto parts you must have 100 pounds of aluminum and 100 pounds of steel, to produce 200 auto parts you must have 200 pounds of aluminum and 200 pounds of steel, and so on. Having extra steel or aluminum without the other metal yields no ad- ditional output—they must be used in fixed proportions. As shown in Figure 5.3, iso- quants from fixed-proportion production functions are shaped as right angles. At the other extreme are perfect substitutes: The inputs can be substituted freely one for an- other. Suppose that one auto part always can be produced using either 2 pounds of steel or 2 pounds of aluminum. In this case, the firm can produce 100 auto parts by using either 200 pounds of aluminum or 200 pounds of steel, or any combination in
M A N A G E R I A L A P P L I C AT I O N S
Baseball Batting Averages Marginal product is above average product when average product is rising and below average product when average
product is falling. This relation is a general property of marginals and averages. A useful illustration is a baseball
player’s batting average. The batting average is defined as the number of hits divided by the number of times at bat.
Suppose a player starts a game with an average of .300. If the player gets two hits with four at bats, the marginal
batting average for the day is .500 and the player’s batting average must rise. If the player gets one hit with four at bats,
the marginal is .250 and the overall average must drop.
10Graphically, marginal product is the slope of a line drawn tangent to the total product curve of that level of
output; average product is the slope of the line connecting a point on the total product curve with the origin. 11Averages and marginals also are equal when the average is at a minimum.
between. As shown in Figure 5.3, the corresponding isoquant is a straight line. Most production technologies imply isoquants that are between these two extremes. As depicted in Figure 5.3, typical isoquants have curvature, but are not right angles. The degree of substitutability of the inputs is reflected in the curvature: The closer the isoquant is to a right angle (the more convex), the lower the degree of substitutability.
Generally, isoquants are convex to the origin (as pictured in the center panel in Figure 5.3—the typical case). Convexity implies that the substitutability of one input
Q u a n tit
y o f a lu
m in
u m
Quantity of steel
300
S
200
100
AFigure 5.2 Isoquants
An isoquant displays all possible ways to produce a given quantity. There is a different isoquant for each possible level of production. This figure shows the isoquants for 100, 200, and 300 auto parts for the production function Q � S1�2A1�2.
Q u a n tit
y o f a lu
m in
u m
Fixed proportions
A
S
Quantity of steel
A
S
Perfect substitutes
Quantity of steel
A
S
Normal case
Quantity of steel
Figure 5.3 Isoquants for Fixed Proportion Production Functions, Perfect Substitutes, and the Normal Case
Production functions vary in terms of how easily inputs can be substituted for one another. In some cases, inputs must be used in fixed proportions and no substitution is possible. Here, isoquants take the shape of right angles. At the other extreme are perfect substitutes, where the inputs can be freely substituted for one another. Here, isoquants are straight lines. Most production functions have isoquants that are between the two extremes. The isoquants in the normal case have curvature but are not right angles.
Chapter 5 Production and Cost 163
164 Part 2 Managerial Economics
for another declines as less of the first input is used. In our example, if the firm is using a large quantity of steel and little aluminum, it can eliminate a relatively large quantity of steel with the addition of only a small quantity of aluminum while keep- ing output the same (see Figure 5.2). In this case, aluminum would be much better suited than steel to construct some components of the auto part. But as the firm uses higher proportions of aluminum, its ability to substitute aluminum for steel declines: Steel is better suited for other components. Most production processes display this property.
Isocost Lines
Given that there are many ways to produce a given level of output, how does Alexi choose the most efficient input mix? The answer depends on the costs of the inputs. Suppose that the firm faces competitive input markets and can buy as much of each input as it wants at prevailing market prices. The price of steel is denoted Ps, whereas the price of aluminum is denoted Pa. Total cost (TC) is equal to the sum of the quan- tities of each input used in the production process times their respective prices. Thus,
TC � PsS � Pa A (5.5)
Isocost lines display all combinations of S and A with the same cost. Suppose Ps � $.50 per pound and Pa � $1 per pound, and the given cost level is $100. In this case,
$100 � $.50S � $A (5.6)
or equivalently,
A � 100 � 0.5S (5.7)
Figure 5.4 graphs this isocost line. Note that the intercept, 100, indicates how many pounds of aluminum could be purchased if the entire $100 were spent on aluminum. The slope of �0.5 is �1 times the ratio of the two prices (Ps �Pa): Since aluminum is twice as expensive as steel, 0.5 pounds of aluminum can be given up for 1 pound of steel and costs remain the same.
Holding the prices of the inputs constant, isocost lines for different cost levels are parallel. Figure 5.4 illustrates this property using the isocost lines for $100 and $200. Note that the further away the line is from the origin, the higher the total cost. Thus, holding output constant, the firm would like to be on the lowest possible isocost line.
M A N A G E R I A L A P P L I C AT I O N S
Substitution of Inputs in Home Building Builders in the Pacific Northwest use large quantities of wood in the construction of residential houses. For instance,
wood is used for framing, siding, floors, roofs, and so on. Home builders in the Southwest (e.g., Arizona) use much
more stucco and tile in home construction. An important reason for this difference is that, in contrast to the Pacific
Northwest, the Southwest does not have large nearby forests. This example suggests that home builders are able to
substitute among inputs in building a home. Home builders in the Southwest, however, still use wood to frame the
house: The substitution of other inputs for wood is not complete.
The slope of an isocost line changes with changes in the ratio of the input prices. As depicted in Figure 5.5, if the price of steel increases to $1, the line becomes steeper (slope of �1). Here, the firm must give up 1 pound of aluminum to obtain 1 pound of steel. Alternatively, if the price of steel falls to $.25 (not depicted in the figure), the line becomes flatter (slope of �0.25). In this case, the firm has to give up only 0.25 pound of aluminum for every pound of steel. Similarly, the slope of the line also changes with changes in the price of aluminum. What determines the slope of the line are the relative prices (recall the slope is �Ps�Pa).
Cost Minimization
For any given level of output, Q*, Alexi will want to choose the input mix that min- imizes total costs. As shown in Figure 5.6, the cost-minimizing mix (S*, A*) occurs at the point of tangency between the isoquant for Q* with the isocost line. Alexi
200
100
200
$100 line $200 line
400
Quantity of steel
Q u a n tit
y o f a lu
m in
u m
A
S
Figure 5.4 Isocost Curves
Isocost lines display all combinations of inputs that cost the same. In this example, Ps � $.50 per pound and Pa � $1 per pound. The figure shows isocost lines for $100 and $200 of expenditures. The slope of an isocost line is �1 times the ratio of the input prices—in this example, �0.5. Isocost lines for different expenditure levels are parallel.
100
100
Ps = $1.00 per pound
Ps = $.50 per pound
200
Quantity of steel
Q u a n tit
y o f a lu
m in
u m
A
S
Figure 5.5 Isocost Lines and Changes in Input Prices
This figure depicts the effect of changes in input prices on the slopes of isocost lines. The solid line shows the isocost line when the price of aluminum is $1 and the price of steel is $.50. The dotted line shows the isocost line where the prices of both inputs are $1. Total cost in each case is $100.
Chapter 5 Production and Cost 165
166 Part 2 Managerial Economics
would like to produce the output less expensively (using an isocost line closer to the origin). However, lower-cost production is not feasible. Alexi could select other input mixes to produce Q*.12 But any other input mix would place the firm on a higher isocost line. Consider the combination (S�, A�) in Figure 5.6. This combina- tion of inputs also produces Q* units of output. Yet this output can be produced at a lower cost by using less aluminum and more steel.
In the appendix to this chapter, we show that at the optimal input mix, the follow- ing condition holds
MPs�Ps � MPa�Pa (5.8)
where MPi is the marginal product of input i. (Recall that the marginal product of an input is described in Table 5.1.) Condition (5.8) has a straightforward interpretation. The ratio of the marginal product to price indicates how much additional output can be obtained by spending an extra dollar on the input. At the optimal output mix this quantity must be the same across all inputs. Otherwise, it would be possible to in- crease output without increasing costs by reducing the use of inputs with low ratios and increasing the use of inputs with high ratios. For instance, if the ratio is 10 units per dollar for aluminum and 20 units per dollar for steel, the firm could hold costs constant but increase output by 10 units by spending one less dollar on aluminum and one more dollar on steel. Alexi has not chosen an optimal input mix when such sub- stitution is possible.
A
S
Q *
S �
A �
A*
S *
Quantity of steel Q
u a n tit
y o f a lu
m in
u m
Figure 5.6 Cost Minimization
The input mix that minimizes the cost of producing any given output, Q*, occurs where an isocost line is tangent to the relevant isoquant. In this example, the tangency occurs at (S*, A*). The firm would prefer to be on an isocost line closer to the origin. However, the firm would not have sufficient resources to produce Q*. The firm could produce Q* using other input mixes, such as (S�, A�). However, the cost of production would increase.
12Note the similarity between this cost minimization problem and the consumer’s utility maximization
problem introduced in Chapter 2. The mathematics are the same—both are constrained optimization
problems. The consumer maximizes utility for a given budget. Cost minimization is equivalent to
maximizing output for a given budget (where the budget is that associated with the lowest-cost method of
producing the output).
Changes in Input Prices
An increase in the relative price of an input will motivate Alexi to use less of that input and more of other inputs. Figure 5.7 illustrates how the optimal input mix for produc- ing Q* changes as the price of steel increases: Alexi chooses less steel and more aluminum to produce the output. This effect is called the substitution effect. The strength of the substitution effect depends on the curvature of the isoquant. The
M A N A G E R I A L A P P L I C AT I O N S
$15 per hour Minimum Wage Increases the Relative Cost of Labor at SeaTac Airport The minimum wage for hotel and car services employees working near SeaTac Airport (Seattle Washington) increased
to $15 per hour at the beginning of 2014, making it the highest in the country. The new minimum was more than twice
the Federal minimum of $7.25 per hour.
Economic theory predicts that SeaTac hotels and car rental agencies will respond to the higher relative price of
labor by substituting capital for labor. For example, a restaurant owner would have increased incentives to convert to
having customers order food with tablet computers located at each table (an increasingly common practice), while a
car rental agency would have increased incentives to use kiosks and other technologies for serving customers.
It is too early to assess all the effects this increase in the minimum wage will actually have on employment in the
area. It depends in part on the ability of companies to substitute capital for labor. Some local hotel managers have
stated that they are in a service industry and are highly unlikely to substitute capital for labor due to the higher wage
rate. The Clarion Hotel, however, within six weeks of the new law, had closed their full-service restaurant and was
considering replacing it with a less labor-intensive café.
Many people have been watching this “experiment” in increasing the minimum wage to such a high level. They
will have to wait to observe the long-run effects, since it takes time for businesses to convert to more capital-intensive
processes, such as using tablet computers for food ordering.
Source: A. Martinez (2014), “$15 Wage Floor Slowly Takes Hold in SeaTac,” Seattle Times (February 13).
A
S
Q *
High steel price
Low steel price
A*2
A*1
S *2 S * 1
Quantity of steel Q
u a n tit
y o f a lu
m in
u m
Figure 5.7 Optimal Input Mix and Changes in Input Prices
This figure illustrates how the optimal input mix for producing a given output, Q*, changes as the price of an input increases. In this example, the price of steel increases and the firm uses less steel and more aluminum to produce the output. This effect is called the substitution effect. The strength of the substitution effect depends on the curvature of the isoquant. The greater the curvature, the less the firm will substitute between the two inputs.
Chapter 5 Production and Cost 167
168 Part 2 Managerial Economics
greater the curvature, the less Alexi will substitute between the two inputs for any given change in prices. The substitution effect helps explain the reactions of automo- bile companies to the 1994 increases in domestic steel prices. These companies in- creased their use of foreign steel. They also searched for additional ways to replace steel with other inputs such as aluminum.
Costs We have analyzed how firms should choose their input mix to minimize costs of pro- duction. We now extend this analysis to focus more specifically on costs of produc- ing different levels of output. Analysis of these costs plays an important role in out- put and pricing decisions.
ANALYZING MANAGERIAL DECISIONS: Choosing the Mix of People and Machines in a Retail Supercenter
You manage a large retail supercenter that sells gro-
ceries and other products to 30,000 customers per
week. Currently, you employ 80 check-out clerks
and 10 automated check-out machines (customers
scan and pay for their purchases without a clerk’s
assistance). Each clerk is paid wages and fringe
benefits of $800 per week. It also costs you $800 per
week to lease each machine (price includes installa-
tion, software support, and servicing). A vendor
has offered to lease you additional machines at this
price. You estimate that by leasing 10 more ma-
chines you can meet your service requirements with
30 fewer clerks. Should you lease the additional ma-
chines or continue to service your customers with
your current input mix?
1. You conduct additional analysis and estimate
that you can service the 30,000 customers with
the following combinations of clerks and ma-
chines. Calculate the total costs for each of these
combinations. What combination of inputs
serves the customers at the lowest possible cost?
Clerks Machines
80 10 50 20 30 30 22 40 15 50 12 60
2. Plot the input combinations in the table on a
graph that contains clerks on the vertical axis
and machines on the horizontal axis. Connect
the points by lines to approximate an isoquant
as pictured in Figure 5.6. Add the cost mini-
mizing isocost curve to the graph (you can
derive this line from the input prices and the
total cost of the low-cost input combination).
How do the slopes of the isocost curve and
isoquant compare at the optimal input
combination?
3. Suppose that the marginal product of clerks
at the optimal input combination is 500.
Explain in words what this means. What is
the marginal product of machines at this
point? Explain why.
4. Suppose that the cost of leasing a machine
declines to $500 per week. What is your new
optimal input mix? How does this affect
your graph?
5. Are there any other factors that should be
considered in making this decision on the
optimal mix of machines and clerks
Discuss briefly.
Cost Curves
The total cost curve depicts the relation between total costs and output. Conceptu- ally, the total cost curve can be derived from the isoquant/isocost analysis discussed above. For each feasible level of output, there is a least-cost method of produc- tion—as depicted by the tangency between the isoquant and the isocost line. The total cost curve simply displays the cost of production associated with the isocost line and the corresponding output. For instance, if the least-cost method of produc- ing 100 auto parts is $1,000, one point on the total cost curve is (100, $1,000). If the least-cost method of producing 200 parts is $1,500, another point is (200, $1,500). Marginal cost is the change in total costs associated with a one-unit change in out- put. Average cost is total cost divided by total output. Managers sometimes refer to marginal cost as incremental cost, whereas they use the term unit cost to refer to average cost.
Figure 5.8 displays the total, marginal, and average cost curves for a hypothetical firm. (This figure illustrates a common pattern for cost curves, although not all firms have cost curves with this same shape.) The upper panel indicates that total cost increases with output. Between zero and Q1, total cost increases but at a decreasing rate (the curve is concave). As shown in the lower panel, over this range, marginal cost
Marginal cost
Q
Q
$
$
Average cost
Total cost
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
T o ta
l c o st
s (i n d
o lla
rs )
Quantity of output
Q1 Q2
Figure 5.8 Cost Curves
This figure displays the total, marginal, and average cost curves of a hypothetical firm. The upper panel pictures total cost. Total cost increases with output. Between zero and Q1, total cost increases but at a decreasing rate (the curve is concave). As shown in the lower panel, over this range, marginal cost decreases. Past Q1, total cost increases at an increasing rate (the curve is convex) and marginal cost increases. Average cost declines where marginal cost is below average cost and rises where marginal cost is above average cost. This relation is a general rule.
Chapter 5 Production and Cost 169
170 Part 2 Managerial Economics
decreases.13 Past Q1, total cost increases at an increasing rate (the total cost curve is convex) and marginal cost increases. Average cost is declining where marginal cost is below average cost and is rising where marginal cost is above average cost. Aver- age cost equals marginal cost where average cost is at its minimum point. As previ- ously discussed, these relations are general rules: They apply to average costs and average products, as well as batting averages and GPAs.
Production Functions and Cost Curves With constant input prices, the shapes of cost curves are determined by the underlying production function. For instance, if the production function displays increasing returns to scale over some range of output, long-run average cost must decline over that range. With increasing returns to scale, a 1 percent increase in input expenditures re- sults in a greater than 1 percent increase in output and average cost must fall. In con- trast, with decreasing returns to scale, a 1 percent increase in input expenditures results in a less than 1 percent increase in output and average cost must rise. Finally, constant returns to scale imply constant average cost. U-shaped curves (as pictured in Figure 5.8) normally are used to illustrate average costs. This slope suggests an initial region of increasing returns to scale, followed by decreasing returns to scale.14
There is also a direct link between the marginal cost curve and the underlying pro- duction function. Recall from Equation (5.8) that cost minimization requires the ratio of the marginal product to price to be equal across all inputs. For illustration, suppose at the optimal input mix to produce 100 auto parts, the ratio of the marginal product to price for both steel and aluminum is 2. By expending $1 more on either input, output increases by 2 units. The reciprocal of this ratio (1�2) is their marginal cost of producing one additional unit of output—if 2 units are produced with $1 of additional expenditure on inputs, the marginal cost of producing one extra unit is $.50. This example indicates that, holding input prices constant, marginal cost is de- termined by the marginal productivity of the inputs: The higher their marginal pro- ductivity, the lower the marginal cost. If the marginal productivities in our example were doubled, the ratio of the marginal product to price would be 4 and the marginal cost would be $.25. The inverse relation between marginal productivity and marginal cost makes intuitive sense. If with a given increase in inputs more output can be pro- duced, the marginal cost of producing that output is lower.
Input prices also can affect the shapes of the cost curves. For instance, a declining average cost can be motivated by discounts on large volume purchases. Similarly, a machine that produces 20,000 units might not be twice as expensive as a machine that produces only 10,000 units. Alternatively, if the firm bids up the price of inputs with large purchases, average cost can rise with increased output. Thus, the long-run average cost curve can slope upward even if the firm does not experience decreasing returns to scale.
13Technical note: The marginal cost at a point is the derivative of total cost (MC � �TC��Q). Graphically, it is equal to the slope of the total cost curve at that point. Thus, marginal cost decreases when the total cost
curve is concave and increases when it is convex. The average cost curve is the slope of the line connecting
a point on the total cost curve with the origin. 14Some economists argue that the typical long-run average cost curve is flat to the right of its minimum
efficient scale. Once that output is reached, additional output can be produced at a constant average cost by
simply replicating the process (the production function does not experience decreasing returns to scale). But
this argument presumes that organizational costs do not increase disproportionally with firm size. See P.
McAfee and J. McMillan (1995), “Organizational Diseconomies of Scale,” Journal of Economics and Management Strategy 4:3, 399–426.
Opportunity Costs Managers must be careful to use the correct set of input prices in constructing cost curves. In Chapter 2, we defined opportunity cost as the value of a resource in its next best alternative use. Current market prices for inputs more accurately reflect opportu- nity costs than historical costs. For instance, if an auto supplier purchases 1,000 pounds of aluminum for $600 and subsequently the market price increases to $900, the oppor- tunity cost of using the aluminum is $900. If the company uses the aluminum, its re- placement cost is $900. Alternatively, the current inventory could be sold to another firm for $900. In either case, the firm forgoes $900 if it uses the aluminum in its pro- duction process.
The relevant costs for managerial decision making are opportunity costs. It is im- portant to include the opportunity costs of all inputs whether or not they have actually been purchased in the marketplace. For instance, if an owner spends time working in the firm, the opportunity cost is the value of the owner’s time in its next best alterna- tive use.
Short Run versus Long Run
Cost curves can be depicted for both the short run and the long run. The short run is the operating period during which at least one input (typically capital) is fixed in sup- ply. For instance, in the short run it might be infeasible to change plant size or change the number of machines. In the long run, the firm has complete flexibility—no inputs are fixed.
The definitions of short run and long run are not based on calendar time. The length of each period depends on how long it takes the firm to vary all inputs. For a cleaning- services firm operating out of rented office space, the short run is a relatively brief period—perhaps only a few days. For a large manufacturing firm with heavy invest- ments in long-lived specialized plant and equipment, the short run might be a rela- tively long time period—it might be a matter of years.
Short-run cost curves sometimes are called operating curves because they are used in making near-term production and pricing decisions. For these decisions, it often is appropriate to take the plant size and certain other factors as given (since these factors are beyond the control of the managers in the short term). Long-run cost curves frequently are referred to as planning curves, since they play a key role in longer-run planning decisions relating to plant size and equipment acquisitions.
Chapter 5 Production and Cost 171
M A N A G E R I A L A P P L I C AT I O N S
Industry Responds to Higher Metals Prices Metals prices rose substantially between 2003 and 2004; for instance, the price of hot rolled steel increased by more
than 80 percent. Manufacturing firms limited the impact of these higher raw materials prices through improved
productivity and switching to less expensive substitutes. For example, some stainless steel makers began to use more
chromium and manganese and less nickel. Craig Yarde of Yarde Metals in Southington, CT, said that the run-up in
prices had benefited his company by increasing the market value of the 40 million pounds of metals in its inventory,
mostly aluminum and stainless steel.
Source: B. Simmon (2004), “Surge in Cost of Metal Squeezes Pricing and Profits,” New York Times (February 26), C1.
172 Part 2 Managerial Economics
Fixed and Variable Costs In the short run, some costs are fixed and do not vary with output. These fixed costs are incurred even if the firm produces no output. For instance, the firm has to pay managers’ salaries, interest on borrowed capital, lease payments, insurance premi- ums, and property taxes whether or not it produces any output. Variable costs change with the level of output. These costs include items like raw material, fuel, and certain labor costs. In the long run, all costs are variable.
Short-Run Cost Curves Figure 5.9 displays the short-run cost curves for the TAM Corporation. For this firm, suppose that the basic plant size is fixed and that all other inputs are variable. The upper panel depicts total cost. Total cost is the sum of the fixed cost (FC) and total variable cost (TVC). The shape of the total cost curve is completely determined by the shape of the total variable cost curve. Fixed costs simply shift up the location of the curve. Between 0 and Q1, the total cost curve is concave. Over this range, the marginal productivity of variable factors increases (assuming fixed input prices). Past Q1, the total cost curve is convex and the marginal productivity of variable fac- tors decreases. This type of pattern is expected given the law of diminishing returns. At low output levels, fixed inputs are not efficiently utilized. Increasing the variable
Marginal cost
Q
Q
$
$ Average total cost
Average variable cost
Average fixed cost
Total variable cost
Total cost
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
T o ta
l c o st
s (i n d
o lla
rs )
Quantity of output
Q1 Q2 Q3
Figure 5.9 Short-Run Cost Curves
This figure displays the short-run cost curves of a hypothetical firm. The upper panel depicts total cost (TC) and total variable cost (TVC). Fixed costs simply shift the position of the variable cost curve. The lower panel depicts marginal and average costs. Average fixed cost declines with output since the fixed cost is being spread over more units. Marginal cost (MC) declines to Q1 and then increases beyond that point due to diminishing returns. Marginal cost depends only on the variable input factors and is completely independent of the fixed cost. Average total cost (ATC) and AVC decline as long as marginal cost is lower than the average cost and increase beyond that point. Marginal cost is equal to both ATC and AVC at their respective minimum points. Average total cost is always larger than AVC, since ATC � AFC � AVC. However, this difference becomes smaller as output increases and AFC declines.
inputs increases output materially. Over this range, total cost increases—but does so at a decreasing rate. Eventually, the marginal productivity of the variable inputs de- clines and it becomes increasingly expensive to produce extra units of output.
The lower panel depicts marginal and average costs. Average fixed cost (AFC) is total fixed cost divided by output. Average fixed cost declines with output since the fixed cost is spread over more units. Marginal cost (MC) declines up to Q1 and then
M A N A G E R I A L A P P L I C AT I O N S
Drugstore Chains “Play Doctor” Due to Increased Demand and Low Variable Costs Large chains, such as CVS, Walgreens, Target and Kroger, operate thousands of retail pharmacies at locations
throughout the United States. In recent years, a growing number of these pharmacies have begun to offer walk-in
clinics for basic medical services, such as vaccinations, diabetes screening, earwax removal, and treatments for sore
throats and the flu. The number of retail pharmacies with medical clinics (as well as the services they provide) is
expected to increase substantially due to expanded insurance coverage under the Affordable Care Act. CVS, currently
the market leader with 800 locations, has plans to open another 150 facilities in 2014.
Many of the costs for providing medical services at these retail locations are fixed. For example, the costs for
leasing the building, electricity, security guards, and much of the staffing would largely be the same whether or not
additional medical services are provided at the given retail location. To be profitable, the chains only have to cover
their variable costs for providing the new service, such as hiring additional nurse practitioners and the direct or
opportunity costs for providing space and seating for waiting patients. CVS charges prices between $79 and $99 for
most of its services. The relatively low prices, relatively quick service, convenient hours, and opportunities to shop
while waiting have proven attractive to many customers.
Not surprisingly, some physician groups have objected to these clinics which compete with them for patients. They
argue that the quality of medical services is inferior at the clinics. Some researchers, however, have found that the
quality of care at these retail clinics is on par with traditional medical offices for certain medical services.
Source: S. Reddy (2014), “Drug Stores Play Doctor: Physicals, Flu Diagnosis, and More,” wsj.com (April 7).
M A N A G E R I A L A P P L I C AT I O N S
Small Airport in “Big Trouble” The difficulties of competing with plant sizes significantly below minimum efficient scale are highlighted by the
problems facing small U.S. airports. Commercial airline companies have cut many flights in recent years at these
airports due to the lack of profitability. It is estimated that U.S. airlines reduced the number of flights by 14 percent
from 2007 through 2012 with midsize and small airports being the hardest hit. As examples, Des Moines, Iowa and
Burlington, Vermont lost 22 and 24 percent of their flights, respectively over this period.
The low volume of passengers and limited number of flights increase the average costs of providing services to
customers at these smaller airports. Airlines that continue to offer flights at these airports have increased their fares
substantially. For example, the small airport at Huntsville, Alabama had the highest average domestic fares among the
tracked airports in the fall of 2013, averaging $559 for a round trip fare compared to the national average of $390. Yet
the economic viability of continuing to offer flights at these many of these smaller airports remains questionable.
Local officials argue that the airports in their smaller communities are good for business and hope that the
convenience to local customers more than offsets the higher ticket prices. Many local fliers, however, opt to drive to
larger airports where the ticket prices are less expensive, the planes larger and the flight options more extensive. Some
local communities have opted to provide financial incentives and subsidies to airline companies to offset their lack of
profitability at their smaller airports. The economic and political viability of these programs, however, remains unclear.
Source: S. Carey (2014), “Why Small Airports are in Big Trouble,” wsj.com (April 7).
Chapter 5 Production and Cost 173
174 Part 2 Managerial Economics
increases beyond that point due to diminishing returns. Note that marginal cost de- pends only on the variable input factors and is completely independent of the fixed cost. Average variable costs (AVCs) are total variable costs divided by output. Both average total cost (ATC) and average variable cost decline as long as marginal cost is lower than average cost; they increase beyond that point. Marginal cost is equal to both average total cost and average variable cost at their respective minimum points. Average total cost is always larger than average variable cost, since ATC � AFC � AVC. However, this difference becomes smaller as average fixed cost declines with higher output.
Long-Run Cost Curves In the short run, firms are unable to adjust their plant sizes. In the long run, however, if a firm wants to produce more output, it can build a larger, more efficient plant. In the long run, the average cost (LRAC) of production is less than or equal to the short- run average cost of production. Indeed, the LRAC curve can be thought of as an envelope of the short-run average cost curves. Figure 5.10 illustrates this concept. The figure shows four potential plant sizes. Each of the four plants provides the low- cost method of production over some range of output, assuming that only these four plant sizes are feasible. For instance, the smallest plant provides the lowest-cost method of producing any output from zero to Q1, while the next largest plant pro- vides the low-cost method of producing outputs from Q1 to Q2, and so on. The heavy portion of each curve indicates the minimum long-run average cost for producing each level of output.
Q1
SRAC1 SRAC2
SRAC3 SRAC4
Q2 Q3 Q
$
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity of output
Figure 5.10 Long-Run Average Costs as an Envelope of Short-Run Average Cost Curves
In the long run, the average cost (LRAC) of production is less than or equal to the short-run average cost (SRAC) of production. The LRAC curve can be thought of as an envelope of the short- run average cost curves. The figure shows four potential plant sizes. Each of the four plants provides the low-cost method of production over some range of output. For instance, the smallest plant provides the lowest-cost method of producing any output from zero to Q1, while the next largest plant provides the low-cost method of producing output from Q1 to Q2, and so on. The heavy portion of each curve indicates the minimum long-run average cost for producing each level of output, assuming that there are only these four possible plant sizes.
If we extend this analysis by assuming there are many different feasible plant sizes that vary only slightly in size, the resulting LRAC curve will be relatively smooth, as pictured in Figure 5.11. This figure also pictures the long-run marginal cost curve (LRMC). As we have discussed, the marginal cost is below average cost where average cost is falling and above average cost where it is rising. The two are equal at the minimum average cost.
Minimum Efficient Scale
Minimum efficient scale is defined as that plant size at which long-run average cost first reaches its minimum point. In Figure 5.11, this minimum occurs at Q *. The minimum efficient scale affects both the optimal plant size and the level of potential competition.
Average production cost is minimized at the minimum efficient scale. As we dis- cuss in the next chapter, competition provides incentives for firms to adopt this plant size. If firms build plants that depart materially from minimum efficient scale, they will be at a competitive disadvantage and could be forced out of business. One com- plicating factor is transportation costs. If transportation costs are high, cost
M A N A G E R I A L A P P L I C AT I O N S
Public Utilities The production of electric power typically is associated with large economies of scale: The average cost of producing
electricity decreases with the quantity produced. This production characteristic implies that it is generally more
efficient to have one large plant that produces power for an area than several smaller plants. A problem with having one
producer of electric power in an area, however, is that the firm has the potential to overcharge consumers for electricity
since there are limited alternative sources of supply. Concerns about this problem provide one motivation for the
formation of public utility commissions that regulate the prices that utility companies can charge consumers.
Q * Q
Long-run marginal
cost
Long-run average cost
$
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity of output
Figure 5.11 Long-Run Average and Marginal Cost Curves
If there are many different plant sizes that vary only slightly in size, the resulting long-run average cost (LRAC) curve is relatively smooth, as pictured in this figure. The long-run marginal cost (LRMC) is below average cost where average cost is falling and above average cost where it is rising. The two are equal at the minimum average cost. The minimum efficient scale is defined as the plant size at which LRACs are first minimized (Q* in this example).
Chapter 5 Production and Cost 175
176 Part 2 Managerial Economics
disadvantages of smaller regional plants can be more than offset by cost savings in transporting the product to customers. In this case, when total production and distri- bution costs are considered, firms with plants that are smaller than the minimum ef- ficient scale can survive in a competitive marketplace.
Generally, the number of competitors will be large and competition more vigorous when the minimum efficient scale is small relative to total industry demand. For instance, suppose that Kate Polk is evaluating the possibility of entering an industry where she sees established firms reporting substantial profits. If her firm would have to produce 10 percent of the market’s output to be cost-efficient, Kate should be con- cerned that her entry is likely to drive the price down and thus she would be less likely to enter the market than if she needed to produce only 1 percent of the market’s output for efficient production.
M A N A G E R I A L A P P L I C AT I O N S
Size Doesn’t Always Matter Regis Corporation has 10,000 beauty salons, buys shampoo by the train load, spends millions on advertising, and uses
sophisticated technology to track performance at each salon. Nonetheless, the 300,000 independent salons in the
United States still compete quite effectively with Regis chains like Supercuts. Paul Finkelstein, Regis CEO says. “We
don’t run a big business. We run ten thousand $300,000 businesses.” He says it’s salon location first, and quality of
stylists second that make the business go. Those are factors that an independent salon also can offer.
Source: F. Bailey (2003), “In Some Businesses, Size Is Irrelevant to Success,” The Wall Street Journal (November 11), B13.
ANALYZING MANAGERIAL DECISIONS: Developing Economies of Scale for Malaysia’s Proton Holdings
Proton Holdings Bhd is a national carmaker in
Malaysia. In late 2007, the Malaysian government
owned 43 percent of the company. The remaining
stock of the company traded on public stock ex-
changes. Proton was among Malaysia’s worst per-
forming companies in 2005, after competition from
foreign carmakers and a lack of new models cost
the firm significant market share and profits. It has
since hired a new chief executive, sold its loss-
making MV Agusta motorbike firm, and pledged to
find a new technology partner. The company has
been under substantial pressure, with its share of
domestic sales falling from 75 percent to 44 per-
cent over the past decade.
Analysts polled in late 2007 noted that the com-
pany’s new management had made several moves
to revamp the company and that these efforts were
bearing fruit in terms of increased sales volume and
market share. New models such as the Persona, a sport edition of Savvy, and Satria Neo were relative
successes. The management also implemented
stringent cost controls. Nonetheless, analysts con-
cluded that Proton’s long-run ability to survive de-
pends on whether it can achieve increased produc-
tion volume and economies of scale. Without
sufficient scale it is unlikely that the company will
survive the intense local and worldwide competi-
tion. The analysts assert that by itself, Proton
would find it hard to achieve economies of scale
and to develop new technologies.
Suppose that you are hired as a consultant to
advise Proton’s management. What do the analysts
mean when they say that Proton needs to achieve
economies of scale to be competitive? Discuss at a
general level the types of actions that the company
might want to consider to achieve the necessary
scale.
Source: K. Fong (2007), “No Economies of Scale for Proton with- out Global Partner,” StarBiz, thestar online (November 21).
Industries where average cost declines over a broad range of output are charac- terized as having economies of scale. Significant economies of scale limit the num- ber of firms in the industry. For instance, if the minimum efficient scale is 25 per- cent of total industry sales, there is room for only four firms to produce at that volume. The level of competition among existing firms can vary significantly, even if there are only a few firms in the industry. However, threat of entry is less press- ing than in industries where scale economies are low. The threat of potential new competitors is often an important consideration in a firm’s strategic planning. In subsequent chapters, we examine how a firm’s market structure affects managerial decision making.
Learning Curves
For some firms, the long-run average cost of producing a given level of output de- clines as the firm gains production experience. For example, with more output, em- ployees might gain important information on how to improve production processes. They also become more proficient as they gain experience on the job.15 A learning curve displays the relation between average cost and cumulative production vol- ume. Cumulative production is the total amount of the product produced by the firm across all previous production periods. Figure 5.12 presents an example where there are significant learning effects in the early stages of production. Eventually, how- ever, these effects frequently become minimal as the firm continues to produce the product.
15A. Alchian (1959), “Costs and Outputs,” in The Allocation of Economic Resources, by M. Abramovitz and others (Stanford University Press: Palo Alto, CA), 23–40.
Average cost of producing Q * units
Cumulative quantity of output produced
Learning curve
$
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
�Q
Figure 5.12 Learning Curve
A learning curve displays the relation between average cost for a given output period, Q*, and cumulative past production. In this example, there are significant learning effects in the early stages of production. These effects become minimal as the firm continues to produce the product.
Chapter 5 Production and Cost 177
178 Part 2 Managerial Economics
Figure 5.13 illustrates the difference between economies of scale and learning ef- fects. Economies of scale imply reductions in average cost as the quantity being pro- duced within the production period increases. Learning effects imply a shift in the entire average cost curve: The average cost for producing a given quantity in a pro- duction period decreases with cumulative volume. Learning effects sometimes can provide existing firms in an industry a competitive advantage over potential entrants; it depends on the nature of the information (Chapter 3) and the distribution of that in- formation across employees. We discuss this issue in more detail in Chapter 8.
Economies of Scope
Thus far, we have focused on the production of a single product. Most firms, however, produce multiple products. Economies of scope exist when the cost of producing a set of products jointly within one firm is less than the cost of producing the products sep- arately across independent firms. Joint production can produce cost savings for a vari-
$
Average cost with low cumulative volume
Average cost with high cumulative volume
Q
Learning effect
C o
st p
e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity of output
Figure 5.13 Economies of Scale versus Learning Effects
This figure shows the average cost curves for a firm when it has experienced high and low cumulative volume. In both cases, there are economies of scale (average cost declines with output). The average cost for each level of output, however, is lower where the firm has experienced high cumulative volume because of learning effects.
Economies of Scale and Learning Effects in the Chemical Processing Industry Marvin Lieberman studied economies of scale and learning effects in the chemical processing industry. He found that
for each doubling in plant size, average production costs fell by about 11 percent. For each doubling of cumulative
volume, the average cost of production fell by about 27 percent. Thus, there is evidence of both economies of scale and
learning effects in the chemical processing industry. The size of the estimates suggests that learning effects are more
important than economies of scale in explaining the observed decline in costs within the industry from the 1950s to
the 1970s.
Source: M. Lieberman (1984), “The Learning Curve and Pricing in the Chemical Processing Industries,” Rand Journal 15, 213–288.
A C A D E M I C A P P L I C AT I O N S
Chapter 5 Production and Cost 179
ety of reasons. Efficiencies can result from common use of production facilities, coor- dinated marketing programs, and sharing management systems. Also, the production of some products provides unavoidable by-products that are valuable to the firm. For instance, a sheep rancher jointly produces both mutton and wool.
Economies of scope help explain why firms produce multiple products. For in- stance, PepsiCo is a major producer of soft drinks; yet it also produces a wide range of snack foods (e.g., corn chips and cookies). These multiple products allow PepsiCo to leverage its product development, distribution, and marketing systems.
Economies of scope and economies of scale are different concepts. Economies of scope involve cost savings that result from joint production, whereas economies of scale involve efficiencies from producing higher volumes of a given product. It is possible to have economies of scope without having economies of scale and vice versa.
Profit Maximization Thus far, we have focused on the costs of producing different levels of output. How- ever, what output level should a manager choose to maximize firm profits? To an- swer this question, we return to the concept of marginal analysis that we initially in- troduced in Chapter 2.
Marginal costs and benefits are the incremental costs and benefits that are asso- ciated with a particular decision. It is these incremental costs and benefits that are important in economic decision making. An action should be taken whenever the incremental benefits of that action exceed its incremental costs. In deciding whether or not to produce one more unit of a product, the incremental benefit is marginal revenue (see Chapter 4), while the incremental cost is equal to marginal production cost (including any distribution costs)—fixed costs do not affect the de- cision. Therefore, the firm should produce extra units so long as marginal revenue exceeds marginal cost; the firm should not produce extra units if marginal revenue
M A N A G E R I A L A P P L I C AT I O N S
Jimmy Beans Wool—Economies of Scope Fail to Materialize Jimmy Beans Wool is an online yarn and fabric seller with a store in Reno, Nevada. The company was founded in 2002
and by 2013 had sales of over $7 million dollars. The company initially focused exclusively on selling yarn. It grew
“organically” at an annual rate of around 50 percent over the period 2007–2012 and earned a national reputation for its
high rate of growth. The owners envisioned that Jimmy Beans could be a $100 million business within a few years. The
owners invested to expand their product line by selling fabrics to grow sales. They made significant investments in
inventory, building remodeling, and marketing. Unfortunately, sales did not grow, and the company suffered a
significant financial setback.
The owners say that they “fell into the trap of thinking if we can sell yarn, we can sell anything.” This is an all too
common managerial misconception that has led to other unsuccessful expansions and mergers. Good managers avoid
this kind of hubris and are careful not to overestimate economies of scope. Economies of scope are most likely to exist
in closely related products where there are true synergies in either production or distribution. The assumption that
economies are produced by a manager who can “manage anything” quite often proves false.
Source: A. Gardella (2014), “Seeking Even Faster Growth, An E-Commerce Company Stumbles,” New York Times (April 2).
180 Part 2 Managerial Economics
is less than marginal cost. At the profit-maximizing level of production, the follow- ing condition holds:16
MR � MC (5.9)
As we saw in Chapter 4, marginal revenue depends on the demand curve for the product. The effective demand curve that the firm faces will be affected by the degree of competition in the product market. In Chapter 6, we examine how the output de- cisions of firms vary across different market settings.
The changes in metal prices throughout the 1990s changed the total cost of auto- mobile manufacturing. Typically, such changes are accompanied by changes in the marginal cost of production. For example, a reduction in steel prices would mean not only a substitution toward steel from other inputs but also an increase in output. Figure 5.14 illustrates this effect. Note that this analysis holds other factors constant. If the demand for automobiles is falling at the same time (thus shifting marginal rev- enue downward), the net effect could be an increase in output. However, the increase in output would be less than if steel prices were constant.
Factor Demand Curves In discussing the optimal input mix, we noted that the following condition must hold for efficient production:
MPi �Pi � MPj�Pj (5.10)
16Technical note: Since profits equal total revenues minus total costs, Equation (5.9) is the first-order
condition for profit maximization. This condition holds at both minimum and maximum profits. At the
maximum, the marginal cost curve cuts the marginal revenue curve from below—the second-order
condition.
$
MC0
MC1
MR
Q * Q * Q
Quantity of output
C o
st /r
e ve
n u e p
e r
u n it
(i n d
o lla
rs )
0 1
Figure 5.14 Changes in Marginal Cost and Optimal Output
This figure illustrates that a decrease in marginal cost (from MC0 to MC1) raises the optimal output of the firm (from Q*0 to Q*1).
Chapter 5 Production and Cost 181
for all inputs i and j. The ratios of marginal product to price reflect the incremental out- put from an input associated with an additional dollar expenditure on that input. The reciprocals of these ratios reflect the dollar cost for incremental output or the marginal cost:
Pi�MPi � Pj�MPj � MC (5.11)
At the profit-maximizing output level, MR � MC. Therefore, at the optimal output level the following condition must hold
Pi�MPi � MR (5.12)
M A N A G E R I A L A P P L I C AT I O N S
China Becomes the “World’s Smokestack” This chapter focuses on how firms choose among alternative input mixes. Another important production decision is where
to locate the plant. Costs can vary dramatically across locations due to differences in the prices for labor, land,
transportation and other inputs, taxes, environmental and safety regulations, threat of terrorism, and political risk. The steel
industry provides a good example of how changes in costs can motivate significant changes in the location of production.
During the 1950s the Ruhr Valley in Germany had the world’s highest growth rate in steel production. In its heyday,
Germany produced 10 percent of the world’s steel supply. In 2006, Germany produced only 3.8 percent of the world’s
supply, ranking seventh behind China, Japan, the United States, Russia, India, and South Korea. China, which has
displayed meteoric growth in steel production, supplied 34 percent.
German steel production slowed in the 1960s as miners had to dig deeper for coal and taxes and labor costs
continued to increase. Another important factor was new environmental regulation. The emissions from steel plants had
made the Ruhr Valley one of the most polluted places in the world. The air was dark and grimy. The residents suffered
from an inordinate incidence of lung and other pollution-related diseases. The white shirts that men wore to church on
Sunday turned to grey by the time they came home. In an effort to “green the country,” the government imposed costly
pollution control requirements on the steel companies.
Differences in labor costs and environmental standards motivated a shift in steel production from Germany to China
as “smoke-spewing plants” were disassembled in the Ruhr Valley and moved 5,000 miles away to China. The Phoenix
steel mills in Dortmund had been among Germany’s largest since before World War II. In the late 1990s, they were
slated for closure and were likely headed for the scrap heap. The Chinese realized that they could buy a relatively
sophisticated German blast furnace for a small fraction of what a new one would cost. A Chinese company sent
workers to Dortmund who labeled every part of the seven-story blast furnace, disassembled it, and packed it into
wooden crates for the voyage to China. They worked day and night to accomplish this task in a much shorter time than
it would have taken German workers, who were governed by strict union and government work rules.
The Hebei Province is “China’s new Ruhr Valley.” Its air is heavily polluted and its citizens suffer from a variety of
associated health problems. Meanwhile, the Ruhr Valley’s pollution level has substantially improved. This
improvement, however, has come at a cost. Dortmund, which in 1960 had 30,000 residents working in the steel
industry, now has less than 3,000. While Dortmund continues to have high unemployment, the decline in steel jobs has
been offset to some extent by new jobs in other less-polluting industries.
The willingness to pay for clean air generally increases with a country’s income. In March 2014, Chinese Premier
Li Keqiang stated in a speech before the Chinese legislature, “we will declare a war on pollution and fight with the
same determination we battled poverty.” Government officials have pledged a series of pollution reforms targeted at
energy-intensive industries, such as steel, aluminum, cement, and coal. Economics, however, teaches us “there is no
free lunch.” Analysts predict that the proposed reforms will increase production cost and potentially force some of the
factories to close.
Source: J. Kahn and M. Landler (2007), “China Grabs West’s Smoke-Spewing Factories,” nytimes.com (December 21); and W. Ma and C.-W. Yap (2014), “China Needs Industry to Enlist a War on Poverty,” Dow Jones Reprints (March 6).
182 Part 2 Managerial Economics
or equivalently,
Pi � MR � MPi (5.13)
Equation (5.13) is the firm’s demand curve for input i.17 It has a straightforward in- terpretation. The right-hand side of the equation represents the incremental revenue that the firm obtains from employing one more unit of the input (the incremental out- put times the incremental revenue). We call this incremental revenue the marginal revenue product (MRPi) of input i. Figure 5.15 illustrates the demand curve for an input.18 At the current input price of P*i, the firm optimally uses Q*i units of the input. The firm optimally employs additional units of the input up to the point where the marginal cost of the input (its price with constant input prices) is equal to the mar- ginal revenue product of the input. Intuitively, if the marginal revenue product is greater than the input price, the firm increases its profitability by using more of the input. If the marginal revenue product is less than the price of the input, the firm in- creases profitability by reducing the use of the input. Profits are maximized when the two are equal.
Our discussion of the profit-maximizing output level and the optimal use of an input might appear to suggest that these decisions are two distinct choices. The two de- cisions, however, are linked directly. Once the firm chooses the quantities of inputs,
17Technical note: The marginal product of input i can depend on the levels of other inputs used in the production process. Thus, the demand curve for an input must allow other inputs to adjust to their optimal
levels as the price of input i changes. This adjustment is not important if the marginal product of input i is not affected by the levels of the other inputs.
18Technical note: The second-order condition for maximum profits ensures that the demand curve for the input
is the downward-sloping portion of the marginal revenue product curve. Thus, Figure 5.15 displays only the downward-sloping portion of the curve.
$
P*i
MRPi
Q * Qi
C o st
/r e ve
n u e p
e r
u n it
o f in
p u t
(i n d
o lla
rs )
i
Quantity of input i
Figure 5.15 Factor Demand Curve
The demand curve for a factor of production is the marginal revenue product curve (MRP) for the input. The marginal revenue product is defined as the marginal product of the input times the marginal revenue. It represents the additional revenue that comes from using one more unit of input. The firm maximizes profits where it purchases inputs up to the point where the price of the input equals its marginal revenue product.
Chapter 5 Production and Cost 183
output is determined by the production function. Thus, profit-maximizing firms choose the output where marginal revenue equals marginal cost and produce that out- put so that the price of each input is equal to its marginal revenue product. In our auto example, an increase in steel prices would be expected to motivate simultaneous ad- justments in both the number of automobiles produced and the methods used to pro- duce them.
M A N A G E R I A L A P P L I C AT I O N S
Hog Producers React to Increase in Corn Prices Pork is the most widely eaten meat in the world, providing about 38 percent of daily meat protein worldwide (despite
the fact that it is not consumed by some people due to religious restrictions). The United States Department of
Agriculture reports that in 2006 the per capita consumption of pork was 43.9 kg, 40 kg, and 29 kg in China, Europe,
and the United States, respectively. Ironically in China’s “Year of the Pig” (2007), there was a crisis that increased pork
prices by 50 percent. The dramatic price increase caused both social unrest and government intervention to “help keep
pork affordable.”
Feed cost is typically about 50–60 percent of the total cost of producing pork. In the United States, corn accounts
for about 80 percent of the typical hog feed. Rising fuel prices and government policies promoting the use of corn-
based ethanol as an alternative to gasoline caused U.S. corn prices nearly to double in the summer and fall of 2006.
This price change significantly increased the cost of feeding hogs. U.S. hog producers were able to lessen the effects of
the increase in corn prices by switching to feed mixes that use less corn and more dried distilled grain and solubles
(DDGS). DDGS is a by-product of the corn-based ethanol production process. Scientists found that DDGS could be
substituted for corn at a 10 percent inclusion rate without having a significant effect on the efficiency, growth, or
carcass traits of the hogs. Corn and DDGS, however, are not perfect substitutes in the hog production process. Feed
mixes with higher DDGS inclusion rates (e.g., 20 percent and 30 percent) produced smaller pigs that offset the
advantages of lower feed costs.
This example highlights a general point about production costs. Increases in input prices increase production costs. The
effect of the price increase often can be mitigated by shifting the input mix toward relatively less expensive inputs. The
ability to reduce costs in this manner depends on the degree of substitutability among the inputs.
Source: J. Lawrence (2006), “Impact on Hog Feed Cost of Corn and DDGS Prices,” Iowa Farm Outlook (November 15), 1–4.
M A N A G E R I A L A P P L I C AT I O N S
Demand for Labor Falls Following 9/11 Terrorist Attacks Organized labor was particularly hard hit by the terrorist attacks following 9/11. Of the 760,000 job cuts in the three
months following the attack, roughly 50 percent were union members—nearly four times organized labor’s
13.5 percent of the U.S. workforce. The reason for this higher-than-average job loss is because unions are
disproportionately represented in the hard-hit travel and tourism industries. Unions representing public employees also
are seeing large job cuts as state and local budgets are cut. September 11 significantly shifted consumers’ demand for
travel and tourism services to the left. When demand shifts to the left, so does the firm’s marginal revenue curve.
Hence, labor’s marginal revenue product—the product of marginal revenue and the factor’s marginal product (holding
constant labor’s marginal product)—also shifts to the left.
Source: A. Bernstein (2001), “A Sock in the Eye for Labor,” BusinessWeek (December 17), 44.
184 Part 2 Managerial Economics
Cost Estimation Our discussion indicates that a detailed knowledge of costs is important for manage- rial decision making. Short-run costs play an extremely important role in operating decisions. For instance, when the marginal revenue from increased output is above the short-run marginal cost of production, profits increase by expanding production. Alternatively, if marginal revenue is below short-run marginal cost, reducing output increases profits. Long-run costs, in turn, provide important information for deci- sions on optimal plant size and location. For instance, if economies of scale are im- portant, one large plant is more likely optimal with the product transported to re- gional markets. Alternatively, if scale economies are small, smaller regional plants, which reduce transportation costs, are more likely optimal.
If managers are to incorporate costs in their analyses in this manner, they must have accurate estimates of how short-run and long-run costs are related to various factors both within and beyond the control of the firm.19 Among the most com- monly used statistical techniques for estimating cost curves is regression analysis. A regression estimates the relation between costs and output (possibly controlling for other factors, such as the product mix or the weather, which affect costs). The data for this analysis can be either time-series data on costs, output, and other vari- ables, or cross-sectional data, which includes observations on variables across firms or plants at a point in time. For instance, in many applications, it is assumed that short-run total costs are approximately linear20
VC � a � bQ (5.14)
where VC is total variable costs for the period and Q is the quantity of output produced.
A detailed discussion of cost estimation is beyond the scope of this book. Suffice it to say that similar problems arise in cost estimation as arise in the case of demand estimation (e.g., omitted-variables problems). Among the most common problems in cost estimation are difficulties in obtaining data on relevant costs. Cost estimates often are based on accounting reports, which record historical costs. As we have in- dicated, these historical costs do not necessarily reflect the opportunity costs of using resources. Moreover, there is the issue of choosing the appropriate functional form. Equation (5.14) presumes a linear model. However, cost curves need not be linear. For instance, it might be appropriate to use a quadratic model, which would include an additional Q 2 term.
One of the more serious problems complicating cost estimation is the fact that most plants produce multiple products. Multiple products are produced in the same plant because there are economies of scope. Rather than produce two different types of cereals in two separate plants, it typically is cheaper to produce them in one plant; fixed resources can be used more efficiently. If a plant produces multiple products, total and average costs for each product can be calculated only by allocating fixed
19In addition, some firms estimate cost curves to obtain insights into their underlying production functions.
Recall that the shapes of cost curves depend on the underlying production functions. Thus, it often is
possible to infer the characteristics of a production function from the shape of the corresponding cost curves.
Typically, the data for estimating cost curves is more readily available than the necessary data for estimating
production functions. 20Variable costs are normally estimated with an intercept. Although variable costs undoubtedly are zero when
output is zero, most cost curves are nonlinear. Forcing the intercept to be zero yields a less precise estimate
of this slope—the change in costs associated with a change in output.
Chapter 5 Production and Cost 185
costs across the products. This allocation often is arbitrary and complicated further by the existence of joint costs. Cost accountants use accounting records to track costs of individual products. Fixed and variable resources used by each product are recorded. These product costs, calculated by the cost accountants, typically are used to estimate short-run and long-run average and marginal costs.
Despite these estimation problems, cost curves play an important role in manage- rial decision making. Nonetheless, it is important that managers maintain a healthy skepticism when using these estimates. For instance, in making major decisions, it generally is instructive for managers to examine whether a proposed decision is still attractive with reasonable variation in the estimated parameters of the cost func- tion—that is, to conduct sensitivity analysis.
Summary A production function is a descriptive relation that connects inputs with outputs. It specifies the maximum possible output that can be produced for given amounts of in- puts. Returns to scale refers to the relation between output and a proportional varia- tion in all inputs taken together. A production function displays constant returns to scale when a 1 percent change in all inputs results in a 1 percent change in output. With increasing returns to scale, a 1 percent change in all inputs results in a greater than 1 percent change in output. Finally, with decreasing returns to scale, a 1 percent change in all inputs results in a less than 1 percent change in output. Returns to a fac- tor refers to the relation between output and the variation in only one input, holding other inputs fixed. Returns to a factor can be expressed as total, marginal, or average quantities. The law of diminishing returns states that the marginal product of a vari- able factor will eventually decline as the use of the input is increased.
Most production functions allow some substitution of inputs. An isoquant displays all combinations of inputs that produce the same quantity of output. The
ANALYZING MANAGERIAL DECISIONS: Rich Manufacturing
Gina Picaretto is production manager at the Rich
Manufacturing Company. Each year her unit buys
up to 100,000 machine parts from Bhagat Incorpo-
rated. The contract specifies that Rich will pay
Bhagat its production costs plus a $5 markup (cost- plus pricing). Currently, Bhagat’s costs per part are $10 for labor and $10 for other costs. Thus the
current price is $25 per part. The contract provides
an option to Rich to buy up to 100,000 parts at this
price. It must purchase a minimum volume of
50,000 parts.
Bhagat’s workforce is heavily unionized. During
recent contract negotiations, Bhagat agreed to a
30 percent raise for workers. In this labor contract,
wages and benefits are specified. However, Bhagat
is free to choose the quantity of labor it employs.
Bhagat has announced a $3 price increase for its
machine parts. This figure represents the projected
$3 increase in labor costs due to its new union
contract. It is Gina’s responsibility to evaluate this
announcement.
1. Why do many firms use cost-plus pricing for
supply contracts?
2. What potential problems do you envision with
cost-plus pricing?
3. Should Gina contest the price increase?
Explain.
4. Is the increase more likely to be justified in the
short run or the long run? Explain.
5. How will a $3 increase in the price of machine
parts affect Gina’s own production decisions?
186 Part 2 Managerial Economics
optimal input mix to produce any given output depends on the costs of the inputs. An isocost line displays all combinations of inputs that cost the same. Cost minimization for a given output occurs where the isoquant is tangent to the isocost line. Changes in input prices change the slope of the isocost line and the point of tangency. When the price of an input increases, the firm will reduce its use of this input and increase its use of other inputs (substitution effect).
Cost curves can be derived from the isoquant/isocost analysis. The total cost curve depicts the relation between total costs and output. Marginal cost is the change in total cost associated with a one-unit change in output. Average cost is total cost di- vided by total output. Average cost falls when marginal cost is below average cost; average cost rises when marginal cost is above average cost. Average and marginal costs are equal when average cost is at a minimum. There is a direct link between the production function and cost curves. Holding input prices constant, the slopes of cost curves are determined by the underlying production technology.
Opportunity cost is the value of a resource in its next best alternative use. Current market prices more closely reflect the opportunity costs of inputs than historical costs. The relevant costs for managerial decision making are the opportunity costs.
Cost curves can be depicted for both the short run and the long run. The short run is the operating period during which at least one input (typically capital) is fixed in supply. During this period, fixed costs can be incurred even if the firm produces no output. In the long run, there are no fixed costs—all inputs and costs are variable. Short-run cost curves are sometimes called operating curves because they are used in making near-term production and pricing decisions. Fixed costs are irrelevant for these decisions. Long-run cost curves are referred to as planning curves, since they play a key role in longer-run planning decisions relating to plant size and equipment acquisitions.
The minimum efficient scale is defined as that plant size at which long-run aver- age cost is first minimized. The minimum efficient scale affects both the optimal plant size and the level of potential competition. Industries where the average cost declines over a broad range of output are characterized as having economies of scale.
A learning curve displays the relation between average cost and the cumulative volume of production. For some firms, the long-run average cost for producing a given level of output declines as the firm gains experience from producing the output (i.e., there are significant learning effects).
Economies of scope exist when the cost of producing a joint set of products in one firm is less than the cost of producing the products separately across independent firms. Economies of scope help explain why firms often produce multiple products.
The profit-maximizing output level occurs at the point where marginal revenue equals marginal cost. At this point, the marginal benefits of increasing output are offset exactly by the marginal costs.
The marginal revenue product of input i (MRPi) equals the marginal product of the input times marginal revenue. Profit-maximizing firms use an input up to the point where the MRP of the input equals the input price. At this point, the marginal benefit of employing more of the input is offset exactly by its marginal cost.
Managers often use estimates of cost curves in decision making. A common statis- tical tool for estimating these curves is regression analysis. One common problem in statistical estimation is the difficulty of obtaining good information on the opportunity costs of resources. Another problem with estimating cost curves involves allocating fixed costs in a multiproduct plant. Cost accountants track the costs and estimate product costs.
Chapter 5 Production and Cost 187
G. Stigler (1987), The Theory of Price (Macmillan: New York), Chapters 6–10.
5–1. The Zimmerman Company digs ditches. It faces the production function, Q � L1�2K, where Q is the number of ditches dug, L is hours of labor, and K is the number of digging tools. a. Complete the following table:
K � 0 K � 1 K � 2 K � 3
L � 0 L � 1 L � 2 L � 3
b. Does the production function display increasing, decreasing, or constant returns to scale? Explain.
c. Are the marginal products of K and L increasing, decreasing, or constant? Explain. d. Assume constant input prices. Draw the general shapes of the following: (1) long-run
average cost; (2) short-run marginal cost, assuming L is fixed; (3) short-run marginal cost, assuming K is fixed.
5–2.21 A product is produced using two inputs x1 and x2 costing w1 � $10 and w2 � $5 per unit, respectively. The production function is y � 5x1
1.5x2 2
where y is the quantity of output, and x1, x2 are the quantities of the two inputs. The marginal products of inputs 1 and 2 for this production function are:
MP1 � 7.5 � x1 0.5
� x2 2
MP2 � 10 � x1 1.5
� x2
a. What input quantities (x1*, x2*) minimize the cost of producing 10,000 units of output? b. What is the total cost of producing the 10,000 units?
Solutions to Self-Evaluation Problems 5–1. a.
K � 0 K � 1 K � 2 K � 3
L � 0 0 0 0 0 L � 1 0 1 2 3 L � 2 0 1.41 2.83 4.24 L � 3 0 1.73 3.46 5.19
b. The production function shows increasing returns to scale. As you increase both inputs by the same proportion, output goes up by a higher proportion (e.g., if you double both
inputs output goes up by more than double). This can be seen along the diagonal of the
table.
c. The marginal product of K is constant. If you hold L fixed and increase K, the marginal increase in output is constant as you add more and more K. You can see this along the
Self-Evaluation Problems
Suggested Reading
21This problem requires slightly higher skills in algebra than most of the other problems in the book. Readers
who cannot work the problem on their own should study the general approach used in the solution to obtain
a better understanding of the conditions for cost minimization.
188 Part 2 Managerial Economics
rows of the table. The marginal product of L is decreasing. If you hold K fixed and in- crease L, the marginal increase in output declines as you add more and more L. This can be seen along the columns of the table.
d. Increasing returns to scale implies that LRAC declines as output is increased (there are economies of scale). The marginal product of K is constant. Thus SRMC is constant when K is the variable input. For example, when L � 1, each additional unit of K produces one extra unit of output (see the second row of the table). In this case, SRMC (the cost of pro-
ducing an additional unit of output) is simply the price of K. The marginal product of L is decreasing. Thus SRMC is increasing when L is the variable input. The general shapes of the graphs are:
5–2. a. The cost-minimizing combination of inputs is found by equating their marginal product to price ratios: MP1�P1 � MP2�P2. This condition can be expressed as:
So, we get
Thus:
x1 � (3�8) x 2 (i) Use the relation in equation (i) to express the production function for y � 10,000 units as a function of only x 2. You now have a solvable equation with one unknown variable, x 2:
Solving for x 2 and obtaining x1 from equation (i):
x 2* � 13.357
x 1* � 5.01
b. The total cost of producing the 10,000 units is simply the sum of the expenditures made to acquire each of the inputs:
TC � w1x1 � w2x 2 � 10 � 5.01 � 5 � 13.357 � $116.87
5–1. Distinguish between returns to scale and returns to a factor.
5–2. Your company currently uses steel and aluminum in a production process. Steel costs $.50 per pound, and aluminum costs $1.00 per pound. Suppose the government imposes a tax of
Review Questions
y � 5x1 1.5x2
2 1 10,000 � 5a3x2
8 b
1.5
(x2) 2 � 5a3
8 b
1.5
x2 3.5
1 3
4 x�11 x2 � 2 1
x 2 x1
� 8
3
MP1
MP2 �
w1 w2
1 7.5 � x1
0.5 � x 2 2
10 � x1 1.5 � x 2
� 10
5
MP1
MP2 �
w1 w2
$/unit $/unit $/unit
Q
LRAC
Q
SRMC (K fixed)
Q
SRMC (L fixed)
Chapter 5 Production and Cost 189
$.25 per pound on all metals. What affect will this have on your optimal input mix? Show
using isoquants and isocost lines.
5–3. Your company currently uses steel and aluminum in a production process. Steel costs $.50 per pound, and aluminum costs $1.00 per pound. Suppose that inflation doubles the price of
both inputs. What affect will this have on your optimal input mix? Show using isoquants
and isocost lines.
5–4. Is the “long run” the same calendar time for all firms? Explain.
5–5. You want to estimate the cost of materials used to produce a particular product. According to accounting reports, you initially paid $50 for the materials that are necessary to produce
each unit. Is $50 a good estimate of your current production costs? Explain.
5–6. Suppose that average cost is minimized at 50 units and equals $1. What is marginal cost at this output level?
5–7. What is the difference between economies of scale and economies of scope?
5–8. What is the difference between economies of scale and learning effects?
5–9. Suppose that you can sell as much of a product as you want at $100 per unit. Your marginal cost is: MC � 2Q. Your fixed cost is $50. What is the optimal output level? What is the optimal output, if your fixed cost is $60?
5–10. Discuss two problems that arise in estimating cost curves.
5–11. Suppose that the marginal product of labor is: MP � 100 � L, where L is the number of workers hired. You can sell the product in the marketplace for $50 per unit, and the wage
rate for labor is $100. How many workers should you hire?
5–12. Textbook authors typically receive a simple percentage of total revenue generated from book sales. The publisher bears all the production costs and chooses the output level. Sup-
pose the retail price of a book is fixed at $50. The author receives $10 per copy, and the firm
receives $40 per copy. The firm is interested in maximizing its own profits. Will the author
be happy with the book company’s output choice? Does the selected output maximize the
joint profits (for both the author and company) from the book?
5–13. Suppose your company produces one product and that you are currently at an output level where your price elasticity is 0.5. Are you at the optimal output level for profit maximiza-
tion? How can you tell?
5–14. Semiconductor chips are used to store information in electronic products, such as personal computers. One of the early leaders in the production of these chips was Texas Instruments
(TI). During the early period in the development of this industry, TI made the decision to price
its semiconductors substantially below its production costs. This decision increased sales, but
resulted in near-term reductions in profits. Explain why TI might have made this decision.
5–15. The AFL-CIO has been a steadfast proponent of increasing the minimum wage. Offer at least two reasons why they might lobby for such increases.
5–16. Mountain Springs Water Company produces bottled water. Internal consultants estimate the company’s production function to be Q � 300L2K, where Q is the number of bottles of water produced each week, L is the hours of labor per week, and K is the number of ma- chine hours per week. Each machine can operate 100 hours a week. Labor costs $20 per
hour, and each machine costs $1,000 per week.
a. Suppose the firm has 20 machines and is producing its current output using an optimal K �L ratio. How many people does Mountain Springs employ? Assume each person works 40 hours a week.
b. Recent technological advancements have caused machine prices to drop. Mountain Springs can now lease each machine for $800 a week. How will this affect the optimal
K�L ratio (i.e., will the optimal K�L ratio be smaller or larger)? Show why.
5–17. The Workerbee Company employs 100 high school graduates and 50 college graduates at respective wages of $10 and $20. The total product for high school graduates is 1,000 �
190 Part 2 Managerial Economics
100Q H, whereas the total product for college graduates is 5,000 � 50QC. Q H � the number of high school graduates, while QC � the number of college graduates. Is the company hir- ing the optimal amount of each type of worker? If not, has it hired too many high school or
too many college graduates? Explain.
5–18. Q TC TFC TVC MC AC AFC AVC
0 1 500 80 2 60 3 50 4 60 5 75 6 95 7 120 8 150 9 185
a. Complete the above table. b. Graph TC, TFC, TVC, MC, AC, AFC, and AVC against Q.
5–19. Suppose the Jones Manufacturing Company produces a single product. At its current input mix the marginal product of labor is 10 and the marginal product of capital is 20. The per
unit price of labor and capital are $5 and $10, respectively. Is the Jones Company using an
optimal mix of labor and capital to produce its current output? If not, should it use more
capital or labor? Explain.
5–20. Suppose the production function of PowerGuns Co. is given by
Q � 25LK
where Q is the quantity of guns produced in the month, L is the number of workers em- ployed, and K is the number of machines used in the production. The monthly wage rate is $3,000 per worker and the monthly rental rate for a machine is $6,000. Currently
PowerGuns Co. employs 25 workers and 40 machines. Assume perfect divisibility of labor
and machines.
a. What is the current average product of labor for PowerGuns Co.? What is the current marginal product of machines? (Assume 1 unit increase in machines.)
b. Does PowerGuns’ production function display increasing, decreasing, or constant returns to scale? Explain.
c. What is the total cost of the current production of PowerGuns in a month? What is the average cost to produce a shooting gun? Assuming the number of machines does not
change, what is the marginal cost of producing one additional gun?
d. What is the law of diminishing returns? Does this production display this characteristic? Explain.
5–21. Assume Canon’s production function for digital cameras is given by Q � 100(L 0.7K 0.3), where L and K are the number of workers and machines employed in a month, respectively, and Q is the monthly output. Moreover, assume the monthly wage per worker is $3,000 and the monthly rental rate per machine is $2,000. (Note: Given the production function, the marginal product functions are MPL � 70(L
�0.3K 0.3 ) and MPK � 30(L 0.7K�0.7 )).
a. If Canon needs to supply 60,000 units of cameras per month, how many workers and machines should it optimally employ?
b. What are the total cost and average cost of producing the quantity given in (a)?
5–22. For simplicity, throughout this problem, assume labor (L), capital (K ), and quantity pro- duced (Q) can be infinitely divided—that is, it is fine to hire 3.3 workers, rent 4.7 machines, and/or produce 134.2 units. Answer the following questions, assuming the production
Chapter 5 Production and Cost 191
function for DurableTires Corp. is Q � L1�3K 1�2, where Q is the quantity of tires produced, L is the number of workers employed, and K is the number of machines rented. a. What is the quantity of tires produced when the company employs 64 workers and
36 machines?
b. What are the average product of labor (L) and the average product of machines (K ) when the input mix is the one given above? Clearly and concisely, please explain how
you would interpret these numbers.
c. Continue to assume the input mix given above: What is the marginal product of labor (L), if the number of workers is increased by 1 unit? What is the marginal product of cap- ital (K ), if the number of machines is increased by 1 unit, instead? Clearly and con- cisely, explain how you would interpret these numbers.
d. Does DurableTires’ production function display increasing, decreasing, or constant re- turns to scale? Explain. Would your answer change, if the production function were
Q � L 1�2K 1�2? How? Explain. e. Does DurableTires’ production function display increasing, decreasing, or constant
returns to labor? Explain. Would your answer change, if the production function were
Q � L 1�2K 1�2? How? Explain.
5–23. Answer the following questions, continuing to assume the production function for DurableTires Corp. is Q � L 1�3K 1�2, where Q is the quantity of tires produced, L is the number of workers employed, and K is the number of machines rented. Moreover, assume the wage per unit of labor (WL) is $50 and the rental price per machine is $200 (WK ). a. What is the total cost of producing the quantity of tires you found in your answer to
question 5–23(a)? And the average cost? Assuming the number of machines rented does
not change, what is the marginal cost of producing one additional tire?
b. Given the production function above, the marginal product of labor and the marginal product of capital are MPL � 1�3(L�2�3K 1�2) and MPK � 1�2(L1�3K �1�2), respectively. Given the wage and rental rate above, is DurableTires Corp. adopting an optimal input
mix to produce the quantity of tires found in question 5–23(a)? If yes, why? If not, why
not, and how could DurableTires Corp. save money producing that same quantity of
tires? Explain.
c. What happens to the optimal input mix you found in question 5–23, if the government introduces a tax that raises the cost of labor to $150 per worker? Explain.
5–24. Assume DurableTires Corp. faces the following demand curve, P � 250 � 0.1Q. If Durable- Tires’ marginal cost is constant at $35, how many tires should it produce in order to maxi-
mize its profits? What’s DurableTires’ profit in this case? Should the elasticity of demand
be greater, equal, or less than 1 at the profit-maximizing price and quantity? Explain (Hint: you may use a graph to support your argument).
Appendix: The This appendix derives the factor-balance equation—Equation (5.9) in the text: Factor-Balance MPi�Pi � MPj�Pj (5.15) Equation22
This condition must hold if the firm is producing output in a manner that minimizes costs (assuming an interior solution).
Recall that at the cost-minimizing method of production, the isoquant curve and isocost line are tangent. Thus, they must have equal slopes. The factor-balance equa- tion is found by setting the slope of the isoquant equal to the slope of the isocost line and rearranging the expression. In the text, we showed that the slope of the isocost line is �Pj�Pi. We now derive the slope of an isoquant.
22This appendix requires a basic knowledge of calculus.
192 Part 2 Managerial Economics
Slope of an Isoquant The production function in the two-input case takes the following general form:
Q � f (xi, xj) (5.16)
To find the slope of an isoquant, we totally differentiate Equation (5.16). We set this differential equal to zero, since quantity does not change along an isoquant:
dQ � [�Q��xid xi] � [�Q��xjd xj] � 0 (5.17) The slope of the isoquant is defined by dxi�dxj. Thus,
Slope of an isoquant � �(�Q��xj)�(�Q��xi) (5.18) � �MPj�MPi (5.19)
This expression has a straightforward interpretation. For illustration, assume that at some fixed combination of xi and xj, the marginal product of i is 1 and the marginal product of j is 2. At this point, the slope of the isoquant is �2. This means that 2 units of i can be given up for 1 unit of j and output will stay the same. This is true by defin- ition since j has twice the marginal product of i.
Factor-Balance Equation When employing the cost-minimizing production method, the slope of the isoquant is the same as the slope of the isocost line:
�MPj�MPi � �Pj�Pi (5.20) Rearranging this expression gives us the factor-balance equation:
MPi�Pi � MPj�Pj (5.21) This expression immediately generalizes to production functions with more than two inputs.
chapter
1 Market Structure chapter
6 C H A P T E R O U T L I N E
Markets
Competitive Markets
Firm Supply
Competitive Equilibrium
Barriers to Entry
Incumbent Reactions
Incumbent Advantages
Exit Costs
Monopoly
Monopolistic Competition
Oligopoly
Nash Equilibrium
Output Competition
Price Competition
Empirical Evidence
Cooperation and the Prisoners’ Dilemma
Summary T he market for cable television has grown tremendously since Home Box Office (a subsidiary of Time Inc.) began broadcasting in 1975.1 Today millions of subscribers purchase multichannel pack- ages from cable companies. Historically consumers in most local
markets had but one choice—purchase cable TV from the one local provider or watch the locally broadcast “free” channels. Subject to regulatory con- straints, local cable companies could set their prices without fear that they would be undercut by the competition. Correspondingly, annual price in- creases for cable TV often exceeded the rate of inflation. According to the Federal Communications Commission, the average monthly price for cable TV rose by more than 90 percent between 1995 and 2005.
In 1994, DirecTV began providing an alternative to cable TV—satellite TV. Initially, customers had to shell out up to $850 for installation and dish equipment, and pay ongoing fees to acquire satellite TV. Many consumers did not consider satellite TV to be a viable alternative because of the price. Fledgling satellite companies were able to attract some customers because
L E A R N I N G O B J E C T I V E S
1. List the basic characteristics of market structure. 2. Explain why perfect competition is a useful benchmark model. 3. Explain a firm’s short-run supply decision and firm and industry supply curves. 4. Explain shutdown and exit decisions. 5. Explain graphically and intuitively long-run equilibrium and how changes in
a market affect the equilibrium in the short and long run.
6. Explain the difference between a constant cost and increasing cost industry. 7. List potential barriers to entry in an industry. 8. Contrast the monopolistic and competitive market outcomes. 9. Define oligopoly and Nash equilibrium.
10. Describe standard economic models of oligopolies focusing on output and price competition, respectively.
11. Describe the “prisoner’s dilemma” and discuss how it relates to cartel incentives.
1Some of the details for this example are from P. Grant (2002), “The Cable Guy Cuts His Rates,”
The Wall Street Journal (September 25); Reuters Limited (2002), “FCC: Cable Prices Rose 7.5% over 12 Months” (April 4); C. Wexler (2006), “Ask Yourself Why . . . Cable Rates Got So High,”
Common Cause (October).
194 Part 2 Managerial Economics
they offered more channels and a clearer digital picture than the typical cable com- pany; they were most successful in locations not served by cable companies.
By 2002, the market had changed significantly. Local cable companies were of- fering more channels and higher quality reception, while satellite companies had lowered their prices and hookup fees substantially. To many consumers, satellite TV and cable TV had become relatively close substitutes. Thus the decision between these two services began to depend more on their relative prices. One consumer who switched from paying $80 per month for Mediacom’s cable service to DirecTV’s satellite service priced at $50 per month summed it up when he said, “I feel like I got everything I had with digital cable but at a lot cheaper price.”
In response to the increased competition, cable company managers initiated several major policy changes. First, they became more competitive in the pricing of cable TV services. Charter Communications, with over 4 million residential subscribers in 2014, is one example of a cable company that altered its pricing policies in response to competitive pressures. In St. Louis, for instance, its basic service of 125� channels for $59.99 per month competed with Dish Network’s service of 120� channels for $29.99 per month and DirectTV’s basic package of 150� channels for $29.99 per month. In addition, Charter faced increased compe- tition from Internet video providers, such as Netflix and Amazon Instant Video. In explaining an earlier price freeze in that market, Charter’s CEO stated, “We’ve got to think twice about rate increases.” Second, cable companies began offering new price/channel packages to cater to various consumer groups with different price/channel sensitivities. For example, AT&T introduced a premium package of 150 channels for $50 per month and an economy package of 100 channels for $40 per month. Previously they only had offered a 125-channel package for $43 month. Third, increased competition also affected the companies’ advertising strategies. For example, companies began promoting the relative benefits of cable TV (such as access to local channels, reduced “rain fade,” not having satellite equipment detract from the appearance of the home, and so on).
The example of cable TV illustrates how policy choices—such as pricing, product design, and advertising—are influenced critically by the market environment. Policies that work within a protected market environment often have to be amended materially when facing a more competitive environment. It is important that managers understand the firm’s market environment and how this set of market circumstances affects deci- sion making. Our purpose in this chapter is to enhance that understanding by exploring the implications of alternative market structures. Our primary focus is on output and basic pricing decisions within different market structures. In subsequent chapters, we examine more complex pricing policies and how other policies, such as aspects of the firm’s strategy and organizational architecture, depend on the market environment.
We begin by discussing markets and market structure in greater detail. We then provide an analysis of competitive industries. Perfect competition is at one end of a continuum based on the environment in which prices are determined within the in- dustry. Competitive markets provide important managerial implications for firms op- erating within a broad class of market settings. Next, we discuss barriers to entry that can limit competition within an industry. This section is followed by an analysis of the market structure at the other end of the continuum: monopoly. In a monopolistic industry, there is but one firm. In contrast to firms in competitive industries, a mo- nopolist has substantial discretion in setting prices. After a brief discussion of a rel- atively common hybrid structure—monopolistic competition—we consider the case of oligopoly, where a small number of rival firms constitute the industry.
Chapter 6 Market Structure 195
Markets A market consists of all firms and individuals who are willing and able to buy or sell a particular product.2 These parties include those currently engaged in buying and selling the product, as well as potential entrants. Potential entrants are all individu- als and firms that pose a sufficiently credible threat of market entry to affect the pric- ing and output decisions of incumbent firms.
Market structure refers to the basic characteristics of the market environment, in- cluding (1) the number and size of buyers, sellers, and potential entrants; (2) the de- gree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit. We begin our analysis of alternative market structures by examining competitive markets.
Competitive Markets Economists generally characterize competitive markets by four basic conditions:
• A large number of potential buyers and sellers
• Product homogeneity
• Rapid dissemination of accurate information at low cost
• Free entry into and exit from the market
Although few markets are perfectly competitive, many markets closely approxi- mate this description. Moreover, competition establishes a benchmark that yields use- ful insights into other market settings. An example of a market that comfortably sat- isfies the conditions for a competitive market is the market for soybeans. In this market, a relatively large number of farmers grow soybeans, and a large number of firms and individuals purchase soybeans. Soybeans are a relatively homogeneous commodity; the product varies little across producers. There are limited informa- tional disparities, and entry as well as exit are essentially costless.
In competitive markets, individual buyers and sellers take the market price for the product as given—no single participant has any real control over price. If a seller charges more than the market price, buyers simply will purchase the product from other suppliers. And firms always can sell their output at the market price; thus they have no reason to offer discounts to attract buyers. In this setting, firms view their de- mand curves as horizontal—a firm can sell any feasible output at the market price, P*—but sells no output at a price above P*. Figure 6.1 illustrates a horizontal demand curve. With a horizontal demand curve, both marginal revenue (MR) and average revenue (AR) equal price.
Firm Supply
Short-Run Supply Decisions In the last chapter, we saw that a firm’s profit is maximized at the output where mar- ginal revenue equals marginal cost. The intuition of this result is straightforward—it makes sense to expand output as long as incremental revenue is greater than
2The specific characteristics of a product often vary across firms. Knowing which firms and individuals to
group together as a market, therefore, is not always straightforward. As discussed in Chapter 4, cross
elasticities are helpful in defining markets. Products with high cross elasticities can be considered in the same
market because they are “close substitutes.”
196 Part 2 Managerial Economics
incremental cost. Past this point, profits decline with additional output since incre- mental revenue is less than incremental cost. In a competitive market, marginal rev- enue is equal to price (P ). In the short run, the firm takes its plant size (and possibly other inputs) as given. The relevant cost is short-run marginal cost (SRMC). The condition for short-run profit maximization in a competitive industry is
P* � SRMC (6.1)
This condition—one of the more important propositions in economics—indicates that at any price, a competitive firm should produce the output where price equals short-run marginal cost. The firm, however, has the additional option of producing no output at all. When the price of the product is insufficient to cover its average variable cost (AVC), the firm is better off if it ceases production. With no output, the firm loses money since it generates no revenue to cover its fixed costs. However, this loss is smaller than the one it would incur if the firm produced any other level of out- put (since revenue from sales would be lower than its variable production costs). Hence the shutdown condition for the short run is
P* � AVC (6.2)
A firm’s supply curve depicts the quantity that the firm will produce at each price. Therefore the firm’s short-run supply curve is that portion of its short-run marginal cost curve above average variable cost. Figure 6.2 highlights this supply curve.
Long-Run Supply Decisions Firms can lose money in the short run yet still find it optimal to stay in business. In the long run, however, a firm must be profitable or it is better to exit this market. Price must equal or exceed long-run average cost (LRAC). Thus, the shutdown condition for the long run is
P* � LRAC (6.3)
$
P *
Q
P ri ce
( in
d o lla
rs )
Quantity (market)
Di = MRi = ARi
$
S
D
P *
Qi Quantity (firm i )
Figure 6.1 Firm Demand Curve in Perfect Competition
In competitive markets, firms take the market price of the product as given. The demand curve is horizontal. Both marginal revenue and average revenue are equal to the market price.
Chapter 6 Market Structure 197
In the long run, a firm can adjust its plant size. The long-run supply decision of a firm is based on long-run marginal costs (LRMC). The long-run supply curve of a firm is that portion of its long-run marginal cost curve above long-run average cost. This supply curve is depicted in Figure 6.3.3
AVCi ATCi
SRMCi
$
Qi
C o st
s p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity (firm i )
Figure 6.2 The Firm’s Short-Run Supply Curve
The firm’s short-run supply curve is the portion of the short-run marginal cost (SRMC) curve that is above average variable cost (AVC). At prices below average variable cost, the firm is better off not producing any output.
3There is no inconsistency between short-run and long-run profit maximization. The LRMC at any given output
is equal to the SRMC, given that the firm has the optimal plant size for the output. Hence, the firm
simultaneously can choose an output where P* � SRMC � LRMC.
LRACiLRMCi
$
Qi
C o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity (firm i )
Figure 6.3 The Firm’s Long-Run Supply Curve
The long-run supply curve for firm i is the portion of the long-run marginal cost (LRMC) curve that is above long-run average cost (LRAC). If price is below LRAC, the firm should go out of business.
198 Part 2 Managerial Economics
LRACi
LRMCi
$ $
Qi Q
D0
P * 1
P *0P *0
P *1
S 1
S0
Q* i1
Q* i 0
Q* 0
Q* 1
P ri ce
a n
d c
o st
p e
r u
n it
o f
o u
tp u
t (i n
d o
lla rs
)
Quantity (firm i ) Quantity
Figure 6.4 Competitive Equilibrium
The left panel illustrates the long-run supply decision of firm i, a representative firm in the industry. In the right panel, supply and demand curves (labeled S0 and D0) determine the market price, P*0. At the price, P*0, the firm produces Q*i0. At the price P*0, the firm is earning an economic profit. This economic profit is the profit per unit (P*0 � LRACi) times the total output Q*i0 and is depicted by the shaded rectangle. Economic profits will motivate other firms to enter the industry. This entry will shift the supply curve to the right and lower the price. Additional entry will occur up to the point where there are no economic profits. This condition occurs at a price of P*1. Here, there are no incentives for firms to enter or leave the industry (incumbents are earning a normal rate of profit and inventories are stable at their desired levels), and the market is in equilibrium. In a competitive equilibrium, firms produce output at the low point on their average cost curves ( P*1 � LRMCi � LRACi). Thus, the equilibrium is associated with efficient production.
Competitive Equilibrium
In Chapter 3, we explained that the market price in a competitive market is determined by the intersection of the industry demand and supply curves. The industry demand curve depicts total quantities demanded aggregated across all buyers in the marketplace at each price. Similarly, the industry supply curve is the sum of all individual supply decisions (discussed earlier). For example, if there are 100 firms in the industry and each produces 20 units at a price of $10, the industry supply at that price will be 2,000 units.
For a graphical illustration of a competitive equilibrium, consider the supply and demand curves, labeled S0 and D0 in the right panel of Figure 6.4. Here, the market price is P*0. The left panel depicts the long-run supply decision of a typical firm in the industry, firm i. At the price P*0, firm i produces the quantity of output Q*i0. Cost curves are defined to include a normal rate of profit (a normal return on capital is one component of LRAC). Thus, at the price P*0, firm i is earning an economic profit (above normal profit). This economic profit is the profit per unit (P*0 � LRAC) times the output Q*i0 and is depicted by the shaded rectangle. The existence of economic profits will motivate other firms to enter the industry.4 This entry will shift the supply
4Profits reported by firms are based on the accounting definition: Sales revenue minus the explicit costs of doing
business. The calculation of accounting profits, therefore, does not include the opportunity cost of the owner’s entrepreneurial effort or equity capital. Economic profits include these costs. Positive economic profits attract
entry because the returns are higher than the returns in the alternative activities. Positive accounting profits do
not always invite entry—the returns do not always cover the opportunity costs of the owners.
Chapter 6 Market Structure 199
curve to the right; inventories will build above their desired levels because of the in- creased production; hence firms will lower price. Additional entry will occur up to the point where there are no longer economic profits. This condition is pictured in Figure 6.4 at a price of P*1. Here, there are no incentives for firms to enter or leave the industry (incumbents are earning a normal rate of profit); inventories are stable at their desired levels and the market is in equilibrium. In a competitive equilibrium, firms produce output at the minimum point on their average cost curves (P* � LRMC � LRAC). Thus, this equilibrium is associated with efficient production.
Constant versus Increasing Cost Industries Standard supply and demand graphs, such as Figures 6.1 and 6.4, usually picture in- dustry supply curves as upward sloping. While short-run industry supply curves typ- ically slope upward, long-run industry curves in many industries are essentially hor- izontal (flat)—supply is perfectly elastic. Whether the long-run industry supply curve is horizontal or upward sloping depends on the incremental costs of expanding industry output.
In the short run, firms have some fixed inputs and entry or exit of firms have not had time to occur. The Law of Diminishing Marginal Returns states that the marginal products of variable inputs will eventually decline as output increases. A firm’s short-run marginal costs will increase once this output level is reached (since the variable inputs are less productive, but cost the same). Upward sloping short-run marginal cost curves imply that both firm and industry supply curves will generally slope upward in the short run (as pictured in the standard graphs). An increase in de- mand for the product will cause the short-run equilibrium price to increase, and ex- isting firms will earn economic profits in the near term. Economic profits, in turn, will induce entry and a resulting long-run fall in price.
Whether the long-run industry supply curve is flat or upward sloping depends on whether the firm is a constant-cost or increasing cost industry. In a constant-cost in- dustry, all existing firms and potential entrants face the same average costs of produc- tion independent of the number of firms in the industry. For instance, they might all have identical cost curves to those pictured for the representative firm in the left panel of Figure 6.4. As an example, consider fast-food restaurants in a large market area. A new restaurant entering this market will likely incur nearly identical costs to existing firms for retail-building space, labor, wholesale food products, and other inputs re- quired for operation. In addition, wage rates and the prices of other inputs are unlikely to be affected with more or fewer restaurants. Thus, the average cost of producing meals is likely to be independent of the number of restaurants in the market area. With
M A N A G E R I A L A P P L I C AT I O N S
Entry in Low-Carb Food An estimated 32 million Americans are following the Atkins Diet and spending $2.5 billion a year on low-carb foods.
Atkins Nutritionals sells 120 products and has licensed its name to dozens of companies. “There’s not much growth in
the food industry and Atkins is getting most of it,” says John McMillin of Prudential Securities. But food giants from
Kraft to General Mills are beginning to offer competing products. For instance, Heinz is introducing its One Carb
ketchup. “Competition is inevitable,” says Atkins President, Scott Kabak.
Source: B. Grow (2003), “The Low-Carb Food Fight Ahead,” BusinessWeek (December 22), 48.
200 Part 2 Managerial Economics
constant costs, the long-run industry supply curve is horizontal at a price equal to the common minimum long-run average cost for firms in the industry (P*1 in Figure 6.4). At higher prices, existing firms earn economic profits, which promotes entry and downward pressure on price. At lower prices, firms do not cover average costs and thus are unprofitable. Some will exit the industry putting upward pressure on price.
With a horizontal (perfectly elastic) long-run supply curve, the long-run market price does not change as demand for the product increases or decreases (price is de- termined by costs, not demand). Rather a change in demand affects only the quantity produced and the number of firms in the industry. For example, if the minimum av- erage cost for firms in a constant-cost industry is $50, the long-run equilibrium price will be $50. This is the only price where no firms have incentives either to exit or to enter the industry. If demand increases or decreases, the price will stay at $50 but the equilibrium quantity will adjust (draw a horizontal supply curve at $50 and view what happens as the demand curve shifts). Our analysis in Chapter 3 describes the ability of suppliers to pass on a per-unit cost increase depends on the relative elastic- ities of supply and demand curves. Perfectly elastic long-run supply curves imply that a cost increase, such as a government excise tax, will ultimately be borne by consumers in the form of higher prices.
In increasing cost industries, the costs of production increase as the number of firms in the industry increases. For example, in many agricultural markets additional output must be produced on less productive farmland, which implies higher per-unit costs. In such an industry, price must increase to induce additional production (since the current price is below the incremental cost of producing additional output). In this case, the long-run supply curve is upward sloping. Here a change in demand will affect both the equilibrium quantity and price.
As we will discuss in more detail in Chapter 8, existing firms in an increasing cost industry often do not earn economic profits when the product price increases due to an increase in demand. Rather, the prices of the inputs that made the initial low-cost production possible (e.g., a particularly productive piece of farmland will sell for a higher price than less-productive farmland) are likely to increase, so that in equilibrium no firm has a cost advantage or economic profits. If the product and
Phantom Freight Most plywood in the United States is produced in the Pacific Northwest. Due to this dominance, plywood prices
throughout the country are essentially the Northwest price plus shipping. If this condition did not hold, Northwest
suppliers would curtail shipping plywood to cities with low prices and increase shipping to cities with high prices. The
changes in supply would affect the prices in the cities until, in equilibrium, the prices across cities would differ only by
transportation costs.
In a U.S. court case, Southeast timber producers were sued for charging customers Northwest’s price plus shipping
and then delivering locally produced plywood. It was ruled that these companies were making unjust profits because they
did not actually incur the shipping costs. The jury awarded billions of dollars to the customers. Were these companies
really making economic profits? The answer is probably not. The local production in the Southeast had a shipping
advantage to Southeast customers. The factor that made this advantage possible was scarce timber land in the Southeast.
Presumably, the price of this scarce timber land was bid up to the point where plywood producers were making only a
normal profit given the prevailing price for plywood in the Southeast (which was the Northwest price plus shipping).
Source: A. Alchian and W. Allen (1983), Exchange and Production: Competition, Coordination and Control (Wadsworth Publishing: Belmont), 228–231.
A C A D E M I C A P P L I C AT I O N S
Chapter 6 Market Structure 201
all the relevant input markets are perfectly competitive, generally no firm in the in- dustry will be able to make economic profits over the long run. It is important for managers to consider this likely reality when they make investment and other strate- gic decisions.
Strategic Considerations Although few markets exactly match economists’ idealized conditions for perfect competition, many markets approximate this structure. In most industries, there are strong competitive forces that reduce economic profits over time. These forces imply that many strategic advantages (e.g., being the first in a new market) are likely to be short-lived. If the conditions in the market resemble the competitive model, it is im- portant to move quickly to take advantage of transitory opportunities. In addition, potential entrants should realize that observed economic profits in an industry are likely to be bid away as time passes. This consideration can affect both long-range capital spending and entry decisions. For instance, given the increased competition, cable TV companies increased the level of scrutiny they applied to internal invest- ment proposals. In a competitive market, firms must strive for efficiency and cost control; inefficient firms lose money and are forced out of the market.
Barriers to Entry5
Although the competitive model is a reasonable approximation in many markets, there are other industries where firms have notable market power—output decisions of individual firms have a noticeable impact on prices. A necessary condition for market power to exist is that there are effective barriers to entry into the industry.
To understand what constitutes an effective entry barrier, it is useful to consider the decisions of individual firms to enter an industry. Firms consider entering a new market when they observe extant firms reporting large profits. For instance, if Wen Ho observes a firm such as a cable TV company reporting large profits, his firm (like a number of other firms) is likely to consider entering the industry. Entry decisions depend on three important factors: First, Wen will be concerned about whether his entry will affect product prices. This depends, at least in part, on how existing firms are likely to respond to a new entrant. For example, are they likely to cut prices? Sec- ond, Wen will be concerned about incumbent advantages. Do existing firms have
ANALYZING MANAGERIAL DECISIONS: United Airlines
The WSJ recently presented data suggesting that United Airlines was not covering its costs on flights
from San Francisco to Washington D.C. The article
quoted analysts saying that United should discon-
tinue this service. The costs per flight (presented in
the article) included the costs of fuel, pilots, flight
attendants, food, etc. used on the flight. They also
included a share of the costs associated with running
the hubs at the two airports, such as ticket agents,
building charges, baggage handlers, gate charges,
etc. Suppose that the revenue collected on the typi-
cal United flight from San Francisco to Washington
does not cover these costs. Does this fact imply that
United should discontinue these flights? Explain.
5This section provides a brief summary of the literature in economics on barriers to entry; it draws on S. M.
Oster (1994), Modern Competitive Analysis (Oxford Press: New York).
202 Part 2 Managerial Economics
advantages that an entering firm will have difficulty duplicating—ones that make it unlikely that the new firm will enjoy similar profits? Third, Wen will be concerned about costs of exit. How much will it cost to leave the industry if this incursion fails? We discuss each of these factors in turn.
Incumbent Reactions
Specific Assets Specific assets are assets that have more value in their current use than in their next best alternative use. Consider the case of the Alaskan Pipeline. It has a high value in its current use. Yet it is completely specialized for transporting oil from the North Slope to Prudoe Bay—it has virtually no other use. Moreover, it could be moved only at enormous expense. If existing firms in an industry have invested heavily in assets quite specialized to that market, they are likely to fight harder to maintain their positions than if their assets are less specific and can be shifted at low cost to alter- native activities.
Scale Economies Industries with significant economies of scale have minimum efficient scales that occur at high output levels. In such industries, a new entrant must produce at high volume to be cost-effective. Large-scale production is more likely to have a material effect on price. For example, if the minimum efficient scale is 30 percent of total mar- ket demand, price certainly will decline if a new entrant tries to capture such a large share of the market—its entry undoubtedly would trigger vigorous price competition from incumbents. Note that the absolute size of the minimum efficient scale is not as important as is this scale relative to the size of the total market. Minimum efficient scale varies enormously across industries. In one study, estimates of minimum efficient scale, as a percentage of industry capacity, ranged from 0.5 percent (fruit/vegetable canning) to 33 percent (gypsum products).6 Globalization of markets increases effective market size, thereby reducing this entry barrier—for example, consider the size of American versus global automobile markets.
Reputation Effects Potential entrants can be influenced by the reputations of existing firms in the indus- try for reactions to new entrants. In certain circumstances, it can pay for an existing firm to react more aggressively than would be implied by considering only its immediate interests. For example, facing a new rival, the firm might engage in extensive price cutting to establish a reputation as a formidable competitor. Note, however, that threats by firms to cut prices if entry occurs sometimes lack credibil- ity. If new firms actually enter, existing firms might not follow through with their threats because they would be harmed by their own price cuts. Thus, it can be rea- sonable for a potential entrant to ignore threats—if the entrant believes that incum- bents are bluffing. We examine these considerations in greater detail in Chapter 9.
Excess Capacity If firms with excess capacity cut production, they can be confronted with much higher average costs (depending on the slopes of their average cost curves). Also, firms with excess capacity are better able to satisfy the demands of new customers
6K. Lancaster and R. Dulaney (1979), Modern Economics: Principles and Policy (Rand McNally: New York), 211.
Excess Capacity at Alcoa In 1940, Alcoa Aluminum lost an important antitrust case involving its production strategy of maintaining excess
capacity. The judge ruled that he could think of no better “effective” deterrent to entry.
H I S T O R I C A L A P P L I C AT I O N S
Chapter 6 Market Structure 203
should they lower price and force a rival out of business. Potential competitors, therefore, may be less likely to enter when there is excess capacity in the industry be- cause they anticipate more aggressive reactions on the part of incumbents.7 Excess capacity frequently exists for completely innocuous reasons. For example, a firm facing cyclical production or anticipating growth has excess capacity over some time spans because it has invested in additional capacity to satisfy peak demands better. In other cases, excess capacity may be chosen specifically to deter entry.
Incumbent Advantages
Precommitment Contracts Existing firms often have long-term contracts for raw materials, distribution outlets, shelf space, and delivery of the final product. These contracts can serve as a deterrent to entry, since they limit the opportunities for customers and suppliers to switch from incumbent firms to new entrants.
Licenses and Patents Sometimes, entry is limited through government restrictions such as licensing require- ments and patents. For instance, the number of doctors is limited effectively by state medical licensing requirements. This restriction allows doctors to charge higher prices than if entry were unrestricted. Regulators and licensed physicians justify such restric- tions with arguments based on consumer protection. Yet, whether or not consumers benefit from stringent licensing is debatable—given that they pay higher prices.
Normal patent life is 17 years. Over this period, other firms are prohibited from copying the innovation; thus a patent provides a firm with potential market power. Patents also provide important incentives to innovate. From a practical standpoint, the effectiveness of a patent in blocking entry varies dramatically (some patents can be circumvented by clever design, e.g.).
Learning-Curve Effects In Chapter 5, we discussed how average costs are reduced in some industries through production experience. As production experience accumulates, the firm learns how to lower unit costs. Learning-curve effects can result in new rivals having a cost disad- vantage relative to existing firms. Whether these effects are important depends on whether the new entrants simply can copy the techniques learned by existing firms through their experience.
Pioneering Brand Advantages Sometimes, a firm benefits from being first in an industry. In some industries—over- the-counter drugs, for example—a satisfied customer might be reluctant to switch
7Excess capacity can occur because of significant declines in industry demand. In this case, profits are likely
to be low and entry will not be attractive. Our current discussion focuses on cases where incumbents are
making economic profits and have excess capacity. These economic profits might not induce entry because
of the fear of price cutting by incumbents.
204 Part 2 Managerial Economics
brands even if the price of a competing product is substantially lower. This tendency is likely to be strongest in experience goods, which have to be tried by the customer to ascertain quality. For instance, customers might hesitate to try a new pain reliever because they fear that it might not be as effective as their regular brand. Where qual- ity can be judged by inspection prior to purchase, this advantage of incumbents is lower. Sometimes the incumbent’s advantage with an experienced good can be over- come by a new entrant through free samples, endorsements, or government certifica- tion. Each of these methods entails additional costs—these costs of overcoming in- cumbent advantages deter entry.
Exit Costs
Another important entry consideration centers on the costs of exit. In some indus- tries, it is possible to “hit and run.” For instance, forming a new company to seal as- phalt driveways requires little investment in specialized equipment or training. A new firm can enter quickly when the profit potential is high and exit at low cost if profits decline. In other industries, especially those with specific assets, exit costs can be high. In such industries firms bear significant costs, such as moving employ- ees to new locations and liquidating plants and other assets when they decide to exit. High exit costs deter initial entry.
Monopoly Effective barriers to entry limit the threat of competition and give incumbent firms market power. Although competitive markets are at one end of the spectrum, at the other end is monopoly —where there is but a single firm in the industry. Here, indus- try and firm demand curves are one and the same.
M A N A G E R I A L A P P L I C AT I O N S
Government Restrictions on Exit Some regulators want to restrict companies from closing plants. These regulators appear motivated by concerns over
people who lose their jobs when a company closes a plant. Restrictions on plant closings, however, are likely to reduce
the desirability of entry into an industry—firms will be reluctant to enter an industry if they cannot exit easily when
they are losing money. Thus, potential effects of government restrictions on exit are less vigorous competition in the
affected industries, higher consumer prices, and lower levels of employment.
M A N A G E R I A L A P P L I C AT I O N S
Entry in Consumer Electronics Since its founding two decades ago, Xoceco Inc. has evolved from producing low-cost color TVs for the Chinese
market to producing flat-screen TVs. They plan to market in the United States by supplying companies like Dell or
Hewlett-Packard. Rather than spending lavishly in chips and software to power their products, they buy the
components, assemble the gadgets, and undercut the industry leaders’ prices. Thus, consumer electronics leaders like
Sony and Matsushita are threatened the way IBM was by the rise of the PC clone.
Source: E. Ramstad and P. Dvorak (2003), “Off-the-Shelf Parts Create New Order in TVs, Electronics,” The Wall Street Journal (December 16), A1.
Chapter 6 Market Structure 205
Profit Maximization Suppose that a monopolist charges the same price to all customers. (As discussed shortly, such a pricing policy might be motivated by either government regulation or the inability to prevent resale among customers; in Chapter 7, we relax this restric- tion.) The firm’s objective is to choose the price–quantity combination along the de- mand curve that maximizes profits. This combination occurs where marginal revenue equals marginal cost.
For purposes of illustration, consider the following linear demand curve:
P � 200 � Q (6.4)
(Assume that marginal cost is constant at $10.) Recall that the marginal revenue curve for a linear demand curve is a line with the same intercept and twice the negative slope. Figure 6.5 displays the demand curve, marginal revenue curve, and marginal cost curve in this example. Optimal output occurs at 95 units—where MR � MC. To sell this output, the firm charges a price of $105. The firm makes $95 profit per unit ($105 � $10) for a total profit of $9,025 ($95 � $95); this is indicated by the shaded rectangle abcd.
As opposed to pure competition, monopolistic suppliers charge customers more than the marginal and average costs of production and distribution; the firm thus earns an economic profit. Monopolies restrict output compared to competitive in- dustries. In our example, if the industry were competitive, the market price would be $10 (marginal cost) and total quantity sold would be 190 units.
Unexploited Gains from Trade Given the monopolist’s output and pricing choices, some consumers are willing to pay more than the marginal cost of production and distribution, yet do not purchase the product. Thus, not all gains from trade are exhausted. The associated loss in
MR
e
c
d MC = AC
105
10
Q
a
b
$
P ri ce
a n d c
o st
p e r
u n it
o f o u tp
u t
Quantity
Q* � 95
P* �
Figure 6.5 Monopoly
This figure illustrates the price and output decisions of a monopolist. In the example, demand is P � 200 � Q. Marginal costs are $10. The profit- maximizing output occurs at 95 units, where MR � MC. To sell this output, the firm charges a price of $105. The firm makes $95 per unit profit ($105 � $10) for a total profit of $9,025 ($ 95 � 95), as indicated by the shaded rectangle abcd. Some consumers are willing to pay more than the marginal cost of production, yet do not receive the product. The associated loss in potential gains from trade is pictured by the shaded triangle cde. The firm does not lower the price to sell to these consumers because it does not want to lower the price for other customers.
206 Part 2 Managerial Economics
potential gains from trade is pictured by the shaded triangle cde in Figure 6.5. Consumers along this segment of the demand curve value the product at more than $10 but less than $105. The firm does not lower the price to sell to these consumers because it does not want to lower the price for other customers (recall that in this chapter we presume the firm charges the same price to all customers). From the firm’s standpoint, any gain from selling to additional customers would be more than offset by the loss from lowering its price to all its customers.8
Monopolistic Competition As the name implies, monopolistic competition is a market structure that is a hybrid between competition and monopoly. In this market structure, there are multiple firms that produce similar products. There is free exit from and entry into the industry. Yet competition does not eliminate market power because the firms sell differentiated products. Examples include retail shops, books, movies, gasoline stations (differen- tiated by location and brand), and business schools. It is the most common market structure. For instance, although many shoe stores compete for customers at a large mall, they are not generally viewed as perfect substitutes. Some position themselves as discount stores, while others target customers who are willing to pay high prices for upscale, branded products. Some stores focus on selling athletic shoes, while oth- ers target conservative business customers. Some focus on women, while others focus on men or children. If any of the existing stores are highly profitable, new stores can enter to compete. These companies thus have some market power. New
ANALYZING MANAGERIAL DECISIONS: Pricing and Investment Decisions
You work for a drug manufacturing company that
holds a patent on Hair Grow, the world’s most
effective drug for restoring hair. Your job is to
analyze the pricing and investment decisions facing
the firm. Your marketing group estimates that Hair
Grow has the following demand curve:
P � 101 � .00002Q
1. Your marginal cost for producing a Hair Grow
pill is $1. What is the profit-maximizing price
and quantity? What is your profit?
2. Suppose that your production facility can
only produce 1,000,000 pills. What is
your optimal price and quantity given the
production constraint? What are your
profits?
3. Suppose that you could increase the capacity
of your plant to 3,000,000 pills within a two-
year period for a cost of $30,000,000. Should
you undertake the investment (for simplicity,
assume you can borrow the funds for the ex-
pansion at a 0 percent interest rate)?
8Economists frequently refer to these lost gains from trade as a deadweight loss. This inefficiency (or social cost) is one reason why governments might pass regulations like antitrust laws to restrict the formation of monopolies. But these regulations also can be motivated by concerns about the higher prices that consumers
pay when they face monopolistic suppliers. Although government regulation has the potential to reduce
inefficiencies and wealth transfers from consumers to firms, it is important to keep in mind that government
regulation is not costless. There are salaries for regulators and court costs, for instance. From a societal
viewpoint, the costs of government regulation should be weighed against the benefits. These issues are
discussed in greater detail in Chapter 21.
Chapter 6 Market Structure 207
stores are likely to enter the industry if the existing firms report large profits—there are no significant barriers to entry.
Monopolistic competition is similar to monopoly in that firms under both market structures face downward-sloping demand curves: A toothpaste company can raise its price without losing all sales. Given that the firms face downward-sloping de- mand curves, each strives to select the price–quantity combination that maximizes its profits. The output decision is based on the same analysis as for the pure monop- olist—choose that output where MC � MR.
The difference between monopoly and monopolistic competition is that in mo- nopolistic competition, economic profits invite entry and imitation. If a shoe store earns high profit from carrying a new product line, others will have an incentive to compete by offering that product line or a very similar line. Entry and imitation will shift the original firm’s demand curve to the left and reduce profits. Zero economic profits exist when the demand curve is shifted to the point where average cost equals price. Figure 6.6 shows this condition.
M A N A G E R I A L A P P L I C AT I O N S
Monopolistic Competition in Golf Balls There are many brands of golf balls. Some golfers view the balls as perfect substitutes and simply purchase the lowest-
priced brand. Other golfers prefer one brand to another. For instance, they might believe one brand of ball flies farther
or provides greater control than competing brands. These golfers are willing to pay a higher price for their favorite ball
than for competing balls. However, they often will substitute if the price difference is more than a few dollars a dozen.
Also, if a company develops some popular feature, like a larger number of dimples on the ball, the feature is typically
copied by other companies within a short time period. Since a golf equipment company has a monopoly in producing its own brand, it has some market power. However, this power is limited given the competition in the industry.
Qi
Di
LRMCi
LRACi
MRi Q *
P *
$
P ri ce
a n d c
o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Quantity (firm i )
i
i
Figure 6.6 Monopolistic Competition
In monopolistic competition, firms sell differentiated products. This figure shows the demand curve for firm i in such an industry. The curve is downward-sloping. Similar to monopoly pricing, the firm selects the output where marginal revenue equals marginal cost. Monopolistic competition differs from monopoly in that abnormal profits will invite entry. Entry shifts the demand curve for the firm to the left (as some of the customers buy from the new firms). The firm makes no economic profits when price is equal to average cost. This condition occurs at price P*i and quantity Q*i.
208 Part 2 Managerial Economics
These competitive responses will tend to force profits to zero. Yet some brands con- tinue to be more distinctive than others. Also, costs can vary because of differences in production techniques and inputs. It is possible for some firms to earn economic prof- its in monopolistic competition.9
Oligopoly Within oligopolistic markets, only a few firms produce most of the output. Examples of oligopolistic industries include automobiles and steel during the 1950s. These in- dustries had important scale economies and other substantial entry barriers. In 1995, the top four cereal makers in the United States produced about 90 percent of industry output, while the top eight accounted for virtually all production. Products may or may not be differentiated. Firms can earn substantial profits. These profits are not reduced through new entry because of effective entry barriers. Yet as we shall see, economic profits sometimes can be eliminated in oligopolistic industries through competition among the existing firms.
In our analysis of other market structures, we assume that firms take the prices of their competitors as given. A firm was not expected to respond to announcements of changes in prices by rival firms. This assumption certainly is reasonable in the case of competitive markets with many small firms, as well as in the case of monopoly with only one large firm. But this assumption rarely is valid within oligopolistic in- dustries. For instance, when American Airlines considers lowering its prices on par- ticular routes, it obviously must be concerned about whether United Airlines and its other competitors will follow suit. In fact, firms in oligopolistic industries ordinarily will be quite concerned about how their rivals will react to most major policy deci- sions, be they advertising campaigns or product design decisions. Decision making within these industries requires strategic thinking. Decision makers must realize that competitors are rational parties operating in their own self-interest. Thus, it is impor- tant for decision makers to place themselves in their rivals’ positions and consider how they might react. (This basic principle, which we now examine briefly, is devel- oped more completely in Chapter 9.)10
Nash Equilibrium
To analyze oligopolies, we need an underlying principle to define an equilibrium when rival firms make decisions that explicitly take each other’s behavior into ac- count. Previously, we used the concept that a market is in equilibrium when firms are doing the best they can, given their circumstances and have no reason to change price
9Monopolistic competition does not exhaust all gains from trade for two reasons. First, as in monopoly, the
firms do not sell to all consumers who value the product at above marginal cost. Second, firms do not operate
at the bottom of their average cost curves (see Figure 6.6). Lower average cost would be obtained with fewer
firms, each producing more output. Nonetheless, regulation to address these inefficiencies is unlikely to be
effective. Consumers value product differentiation and are arguably better off with more variety at slightly
higher average cost than with lower variety produced at lower average cost. Second, with few entry barriers,
the market power of firms is unlikely to be great. 10This chapter presents a basic introduction to game theory. The material provides sufficient background for
the game theory applications found in subsequent parts of the book (these are in the appendices of several
chapters). Chapter 9 extends this introduction of game theory and discusses in more detail how managers
might use this theory as a tool in decision making. Readers interested in a more detailed treatment of game
theory should read Chapter 9.
Chapter 6 Market Structure 209
or output. For example, in a competitive equilibrium, there is no reason for entry or exit (existing firms are making “normal” profits). No existing firm has any reason to change its output level (all are producing where MC � MR � P* and inventories are stable at their desired levels).
We can apply this same basic idea to oligopolistic markets with minor modifica- tion. In the following analysis, a firm does the best it can, given what its rivals are doing. In doing so, the firm anticipates that other firms will respond to any action it takes by doing the best they can as well. Actions are noncooperative in that each firm makes decisions that maximize its profits, given the actions of the other firms. The firms do not collude to maximize joint profits. An equilibrium exists when each firm is doing the best it can, given the actions of its rivals. Economists call this a Nash equi- librium for Nobel laureate John Nash who first developed these general concepts.
To illustrate this approach, assume a simple setting: There are two firms in an indus- try—a duopoly. Each independently chooses a price for an identical product. The firms choose either a high price or a low price. The payoffs are given in Figure 6.7. (The entry on the upper left in each cell is for WonCo, while the entry on the lower right is for TuInc.) For example, if both firms charge a high price, WonCo’s profits are $400 and TuInc’s profits are $200.11
The equilibrium is for WonCo to charge a high price and TuInc to charge a low price. Any other combination is unstable: Given the action of one of the firms, the other firm has the incentive to change its price. For instance, if both firms charge a high price, it is in the interests of TuInc to lower its price—its profits go from $200 to $250. The other combinations of WonCo charging a low price and TuInc a high price and both firms charging a low price are similarly unstable: Each firm has an incentive to alter its price given the other firm’s choice. A Nash equilibrium is self-enforcing. If WonCo charges a high price, it is optimal for TuInc to charge a low price. Similarly, if TuInc charges a low price, it is optimal for WonCo to charge a high price. Given the choice of one firm, there is no reason for the other to alter its strategy.
$20
$40
TuInc—Low price
W o
n C
o —
L o
w p
ri ce
$40
$0
TuInc—High price
W o
n C
o —
L o
w p
ri ce
$250
$200
TuInc—Low price
W o
n C
o —
H ig
h p
ri ce
$200
$400
TuInc—High price
W o
n C
o —
H ig
h p
ri ce
Figure 6.7 Nash Equilibrium
In this example, there are two firms in an industry—WonCo and TuInc. Each independently chooses a price for an identical product. The firms choose either a high price or a low price. The payoffs are given in the table (the upper-left entry in a cell displays the profits for WonCo, the lower right shows the profits for TuInc). The equilibrium is for WonCo to charge a high price and TuInc to charge a low price—the shaded cell. Any other combination is unstable: That is, given the action of one of the firms, the other firm has the incentive to deviate. This equilibrium is called a Nash equilibrium.
11The profits differ due to differences in the underlying production costs.
210 Part 2 Managerial Economics
In this example, the Nash equilibrium is not the outcome that maximizes the joint profits of the two companies. Combined profits would be higher if both firms charged a high price. Conceptually, the combined profits under this pricing policy could be split in a manner that would make both firms better off than in the Nash equilibrium. For instance, the combined profits of $600 could be split, with each firm receiving $300. As this example illustrates, noncooperative equilibria do not neces- sarily maximize the joint value of the firms. (Since the potential gains from trade are not exhausted, it is often the case that one or more firms can be made better off, with- out making other firms worse off, by changing the joint decisions.)
Output Competition
The first major analysis of oligopoly was published by Augustine Cournot in 1838. To illustrate his model, suppose again that there are only two firms in the industry and that they produce identical products. In the Cournot model, each firm treats the output level of its competitor as fixed and then decides how much to produce. In equilibrium, neither firm has an incentive to change its output level, given the other firm’s choice. (Thus, this is a Nash equilibrium.)
Suppose the duopolists face the following total industry demand:
P � 100 � Q (6.5)
where Q � QA � QB. For simplicity, assume that both firms have marginal costs of zero: MCA � MCB � 0. Each firm takes the other firm’s output as fixed. Thus, the anticipated demand curve for firm i (i � A or B) is
Pi � (100 � j) � Q i (6.6)
where j � expected output of the other firm. The marginal revenue for firm i is 12
MRi � (100 � j) � 2Q i (6.7)
Firm i ’s profits are maximized by setting marginal revenue equal to marginal cost (in this case, zero). Doing so, and rearranging the expression, yields the following reaction curve:
Q i � 50 � 0.5Q j (6.8)
The reaction curve indicates firm i ’s optimal output given the output choice of firm j. Both firms have the same reaction curve in this example, except that the subscripts are reversed.
Equilibrium occurs where the two curves cross. At these output levels, each firm is maximizing profit given the other firm’s output choice. Neither firm has an incentive to alter its output. The equilibrium is pictured in Figure 6.8. In equilibrium, each firm produces 33 units for a total output of 66 units; the price is $33.34. This output level is lower than in a competitive market. With competition, total output would be 100 units and the price would be zero (where P* � MC). In the Cournot equilibrium, firms make economic profits: Price is $33.34; average costs are zero. Each firm thus reports profits of $1,110.89. This profit is lower than the two firms could obtain if they directly col- luded and jointly produced the monopolistic output of 50 units (e.g., 25 units per firm). With effective collusion, joint profits would be $2,500 rather than $2,221.78. Figure 6.9
Q
Q
Q
12Recall that marginal revenue for a linear demand curve is a line with the same intercept, but twice the
negative slope.
Chapter 6 Market Structure 211
Collusion
Cournot
Competition MC = 0
66.66 100 Q
MR
50 0
33.34
50
100
$
Quantity
P ri
ce (
in d
o lla
rs )
Figure 6.9 Comparison of Prices and Outputs among Collusive, Cournot, and Competitive Equilibria
In this example, the total industry demand curve is P � 100 � Q. Marginal cost is zero. The figure shows the price–quantity outputs for the industry under collusive, Cournot, and competitive equilibria. The output is smallest and the price is highest for the collusive equilibrium. The output is largest and the price is smallest for the competitive equilibrium.
Firm A’s reaction curve
Firm B’s reaction curve
a = Competitive equilibrium b = Cournot equilibrium c = Collusive (monopoly) equilibrium
a
b
c
100
50
33.33
33.33
25
25 50 100
Q B
QA
Q u
a n
ti ty
o f
o u
tp u
t b
y F
ir m
B
Quantity of output by Firm A
Figure 6.8 Cournot Equilibrium
The duopolists in this example face the total industry demand curve, P � 100 � Q, where Q is the sum of the two outputs. Both firms face a marginal cost of zero. The figure shows the reaction curves for each firm. The reaction curve indicates firm i’s optimal output given the output choice of firm j ( i, j � A or B). The Cournot equilibrium occurs where the two reaction curves cross. Each firm produces 33.33 units. The market price is $33.34. The output for the firms is lower and the profits are greater than in the competitive equilibrium. The output for the firms is greater and the profits are lower than in the collusive (monopoly) equilibrium.
ANALYZING MANAGERIAL DECISIONS: Entry Decision
In the simple Cournot model, firms make their
output choices simultaneously. In practice, firms
sometimes make these kinds of decisions
sequentially.
Suppose that you manage one of the firms
discussed in the Output Competition example in the text. The industry demand in this example is
P � 100 � Q and the MC of each firm is zero.
1. Suppose that each firm must make an upfront
investment of $1,000 to enter the market and
that your competition has already paid this
investment and chosen to produce 50 units.
This investment is nonrecoverable (sunk).
Should you make the $1,000 investment and
enter the market? If so, how much should you
produce and what are your profits? Continue to
assume that your firm will survive for only one
production period.
2. How do your profits and those of your
competitor compare to the case of simultane-
ous decisions discussed in the text? Would you
say that this example of output competition has
a first mover advantage or disadvantage?
212 Part 2 Managerial Economics
displays the three price–quantity outcomes using the original industry demand curve. (This model can be extended readily to more than two firms. The same general results hold: As the number of firms grows, outcomes approach those of a competitive market.)
Price Competition
In the Cournot model, firms focus on choosing output levels. An alternative possi- bility is that firms might focus on choosing product price.13 Here, the Nash equilib- rium is for both firms to choose a price equal to marginal cost—the competitive out- come. To see why, suppose one of the firms chooses a price, P� � MC. In this case, it is optimal for the rival firm to charge a price just below P� to capture all industry
13This situation often is referred to as the Bertrand model. Bertrand was a French economist who wrote a short
note almost 50 years after Cournot’s work was published arguing that in some markets, producers set prices
rather than quantities.
M A N A G E R I A L A P P L I C AT I O N S
Price Wars Firms in oligopolistic industries sometimes engage in intense price competition to their mutual detriment. Examples
include the airline and wireless industries. The major airlines, including American, United, Delta, and Northwest,
periodically enter fare wars that lower the price of air travel for consumers and lower the combined profits of the
airline industry. For instance, in 2005 Delta lowered its fares in the hope of gaining new passengers. This price
reduction was matched by other airlines within hours. In 2002 wireless carriers such as Sprint PCS, AT&T Wireless,
and Verizon stole each other’s customers offering look-alike calling plans and rock-bottom prices. As soon as one
company offered a new calling plan, the rest followed suit. Outside analysts generally agree that the firms lose profits
through these price cuts. Financial analysts following the stocks of wireless service companies recommended to their
clients that they reduce the amount invested in this sector because intense price competition was lowering profits.
Source: S. Mehta (2001), “First That Old Sinking Feeling,” Fortune (December 10), 34–35; and M. Rollins (2002), “Wireless Services Second Quarter Preview: Less Than a Zero Sum Game,” Solomon Smith Barney Industry Note (July 8); J. Horwich (2005), “Northwest Matches Delta’s Fare War . . . Reluctantly,” Minnesota Public Radio (January 5).
Chapter 6 Market Structure 213
sales. (Since we assume the firms’ products are identical, customers buy the product from the firm that offers the lower price.) Given that the second firm charges a price just below P�, it is now optimal for the first firm to charge a slightly lower price. This process continues; only when price equals marginal cost does neither firm have an incentive to lower price. (Lowering price further would result in selling below cost, thus generating a loss.) Of course, both firms would like to devise a way of avoiding competition and capturing higher profits. Yet as we discuss below, fostering cooper- ation can be difficult—and in certain cases, illegal.
Empirical Evidence
There are various economic models of oligopoly. We have presented but two of them simply to illustrate that economic theory does not make unambiguous predictions about what to expect within such industries. Some models yield outcomes close to pure competition—firms sell at marginal cost and make no economic profits. Other models yield outcomes closer to pure monopoly. What actually occurs in oligopolis- tic markets depends on the specific market and competing firms (there is no one model that fits all situations). It is ultimately an empirical issue. Available evidence
Price Competition with Differentiated Products We demonstrated in the main text how price competition could lead to zero economic profits in an oligopolistic
industry. The analysis focused on two firms producing homogenous (identical) products. Often competing firms produce differentiated products. Products are horizontally differentiated when at the same price some consumers buy one and some buy the other. For example, Ford and General Motors (GM) engage in price competition in most
segments of the car market, but consumers do not view their products as perfect substitutes. At the same price, some
would buy a Ford, while others would buy a Chevy (produced by GM). A given customer, however, might be induced to
purchase her less-preferred product with a sufficient price discount. Ford and GM are likely to consider this possibility
when they price their products. Economists refer to price competition in this setting as Bertrand Competition with Differentiated Products.
The basic economic model of this competition considers two firms, producing horizontally differentiated products.
The degree of differentiation ranges from D � 0 (all customers view the products as homogenous and thus perfect substitutes) to D � 1 (complete differentiation, where a given customer does not substitute from one product to the other based on price). Depending on the degree of differentiation, it is possible for both firms to earn long-run
economic profits in this setting, even if they compete on price. Both firms earn zero economic profits when they are
viewed as perfect substitutes (D � 0)—the case analyzed in the text. Profit increases with the degree of differentiation. With complete differentiation (D � 1), each firm can simply price as a monopolist to the set of customers who prefer its product (since customers do not view the products as substitutes). Profits fall with the degree of substitution since
the firms have increased incentives to lower price to attract additional customers from the other firm. In equilibrium,
price competition makes each firm worse off than if they had been able to collude on price.
Managers invest in marketing, advertising, packaging, and new product design to differentiate their products from
competitors. Interestingly, successful differentiation can benefit not only the investing firm, but also the competing
firms (there is a positive externality). The investing firm gains by having increased pricing power to extract profits from
customers who prefer its products. However, by definition the other firm is also more differentiated, which allows it to
extract additional profits from the customers who prefer its products. For example, suppose a firm is successful in
promoting its clothing line among teenagers. While teenagers would be more likely to buy the product, more
conservative adults might be more likely to buy the other.
A C A D E M I C A P P L I C AT I O N S
214 Part 2 Managerial Economics
suggests that oligopolies typically result in less output than competitive markets and that firms earn economic profits—at least in some industries.14 Firms sometimes compete on price, to each other’s detriment, and normally earn less in aggregate than a monopolist could.
Cooperation and the Prisoners’ Dilemma
As we have discussed, in oligopolistic industries it is in the private interests of firms to find ways to cooperate and capture more profits than through competition. In prin- ciple, firms are most profitable if they effectively collude and act as a monopolist in jointly setting price and output for the industry. Collusion maximizes joint profits, which then can be divided among the firms in the industry. Many governments un- derstand these incentives and have passed a variety of antitrust laws to limit firms’ ability to engage in fixing prices. These laws are designed to lower the prices con- sumers pay for products. Some of the more restrictive of these laws have been adopted in the United States. Internationally, firms tend to have more latitude in forming cooperative agreements in attempting to increase profits—for example, con- sider the OPEC cartel.15
Prisoners’ Dilemma Even when free to cooperate, firms find that cooperation is not always easy to achieve. Individual firms have incentives to “cheat” and not adhere to output and price agreements. This incentive can be illustrated by the well-known prisoners’ dilemma. In the original prisoners’ dilemma, there are two suspects; hence, suppose the SEC has been investigating an insider trading scheme and their investigation is focused on two securities brokers, Avi Wasserman and Bea Haefner, who are arrested and charged with a crime. Police have insufficient evidence to convict them for in- sider trading violations unless one of them confesses. The police place Avi and Bea in separate rooms and try to get them to confess. If neither confesses, they are con- victed of less serious crimes associated with their trading activities and are sentenced to only 2 months in jail. If both confess, they spend 12 months in jail. However, if one confesses but the other does not, the confessor is released under a plea bargain in return for testifying while the other is sentenced to 18 months in jail—12 for the crime and 6 for obstructing justice. The payoffs in terms of jail time faced by each individual are displayed in Figure 6.10.
The Nash equilibrium is for both suspects to confess. Given these payoffs, it is al- ways in the individual interests of each suspect to confess, taking the action of the other party as given. If Avi does not confess, Bea is set free by confessing. Alterna- tively, if Avi confesses, Bea reduces her jail sentence from 18 to 12 months by also confessing. Either way, it is in Bea’s interests to confess—confessing is a dominant strategy. Since the payoffs are symmetrical, it also is optimal for Avi to confess. Although it is in the individual interests of each party to confess, it is clearly in their joint interests not to confess. By not confessing, each only serves 2 months in jail,
14D. Carlton and J. Perloff (1990), Modern Industrial Organization (HarperCollins: New York), Chapter 10, discusses some of the relevant empirical literature.
15In smaller countries, much of the local production of key products is exported. In this case, it can be in the
countries’ interests to allow the formation of cartels. Ultimately, consumers pay higher prices and there are
inefficiencies. However, many of these costs are imposed on people in other countries.
Chapter 6 Market Structure 215
compared to 12 months if both confess. The prisoners’ dilemma suggests that any agreement for neither to confess is likely to break down when they make their indi- vidual choices unless there is some mechanism to enforce their joint commitment not to confess. (For particular crimes one such mechanism might be the Mob: Both suspects have incentives not to confess if they expect to be executed for providing evidence to the police.)
Cartels Cartels consist of formal agreements to cooperate in setting price and output levels. (These activities are generally illegal in the United States.) Firms trying to maintain cartels can face a problem like the prisoners’ dilemma—we might call it the cartel’s dilemma. Members can agree to restrict output to increase joint profits. However, in- dividual firms have incentives to cheat. If all other firms restrict output, prices will not be affected significantly by the extra output of one firm. However, that firm’s profits will increase from selling additional output at the cartel-maintained high price. But if all firms react to these incentives by increasing output, the cartel breaks down. Actual cartels often unravel because of such incentives. This outcome is
2 months
2 months
Bea—No confession Bea—Confession
A vi
— N
o c
o n
fe ss
io n
A vi
— N
o c
o n
fe ss
io n
0 months
18 months
18 months
0 months
Bea—No confession Bea—Confession
A vi
— C
o n
fe ss
io n
12 months
12 months
A vi
— C
o n
fe ss
io n
Figure 6.10 Prisoners’ Dilemma
In the prisoners’ dilemma, there are two suspects: Suppose the SEC has been investigating an insider trading scheme and their investigation is focused on two securities brokers, Avi Wasserman and Bea Haefner, who are arrested and charged with a crime. The police do not have sufficient evidence to convict them for insider trading unless one of them confesses. The police place the suspects in separate rooms and ask them to confess. If neither confesses, they are convicted of minor violations uncovered by the investigation of their trading activities and are sentenced to 2 months. If both confess, they spend 12 months in jail. However, if one confesses and the other does not, the confessor is released under a plea bargain in return for testifying but the other is sentenced to 18 months in jail—12 for the crime and 6 for obstructing justice. The payoffs in terms of jail time faced by each individual are displayed. Each entry in the table lists the jail sentences for Avi and Bea, respectively. The Nash equilibrium is for both suspects to confess—the shaded cell. Given the payoffs, it is always in the individual interests of each suspect to confess (taking the action of the other party as given).
216 Part 2 Managerial Economics
displayed in Figure 6.11, which displays the payoffs for two firms attempting to form a cartel. It is in their joint interests to restrict output. Yet, as in the prisoners’ dilemma, both firms have individual incentives to renege and increase output. The Nash equi- librium is for each to increase output.
A cartel can persist if it can impose sufficient penalties on cheaters. But for these penalties to be effective, cartel members must be able to observe (or reliably infer) that a firm has cheated. To the extent that cartel members expect to interact on a repeated basis, there are greater incentives to cooperate. Repeated interaction also increases incentives to invest in developing effective enforcement mechanisms to limit cheating. Potentially, these incentives can be strong enough to resolve the car- tel’s dilemma. In general, cooperation is easier to enforce if the number of firms in the industry is small: It is easier to identify and punish cheaters.
Even when firms are not permitted to form cartels, there may be ways of cooperat- ing to increase profits. For example, over time, a firm might become known as a price leader. Such a firm changes prices in the face of new demand or cost conditions in a way that approximates what a cartel would do. Other firms follow the price changes, thus acting like members of a cartel. Individually, firms still can have short-run in- centives to cheat (e.g., reducing price to get more sales). However, firms might resist this short-run temptation to foster cooperation in the long run and hence obtain higher long-run profits.16
Another potential mechanism to foster cooperation is the structure of contracts with buyers employed by firms in the industry. Most-favored-nation clauses provide buyers with guarantees that the seller will not sell to another buyer at a lower price. These clauses reduce incentives of sellers to lower the price for one buyer because that same price concession would have to be offered to other buyers as well. Meeting-the-
$500
$500
A V
In c—
L o
w o
u tp
u t
A V
In c—
L o
w o
u tp
u t
$150
$600
$600
$150
BeaCo—Low output A
V In
c— H
ig h
o u
tp u
t BeaCo—High output
BeaCo—Low output BeaCo—High output
A V
In c—
H ig
h o
u tp
u t
$200
$200
Figure 6.11 Cartel’s Dilemma
Two firms, AVInc and BeaCo, attempt to form a cartel. If both firms restrict output, prices are high and each firm’s profit is $500. If both cheat on the cartel and increase output, price will be low and each firm’s profit is $200. If one firm expands output while the other restricts output, the market price will be at an intermediate level; the firm with the high output will make $600 (because of the increased sales), but the other firm will only make $150 (because of the lower price). These payoffs are displayed. The Nash equilibrium is for both firms to increase output—the shaded cell. Given the payoffs, it is always in the interest of each firm to increase output (taking the output of the other firm as given).
16Indeed, economists have shown that within any long-term relationship, with no specified ending date,
cooperation is a possible equilibrium—the parties need not succumb to the cartel’s dilemma. We discuss this issue in more detail in Chapter 9 and in the appendix to Chapter 10.
Chapter 6 Market Structure 217
competition clauses guarantee that a seller will meet the price of a competitor. Such a clause makes it difficult for firms to cheat on an agreement not to lower price since price concessions are more likely to be brought to each other’s attention by customers.
Our discussion of these strategic interactions among rivals in output markets is meant only to provide a basic introduction to these issues.
Summary A market consists of all firms and individuals who are willing and able to buy or sell a particular product. These parties include those currently engaged in buying and selling the product, as well as potential entrants. Market structure refers to the basic characteristics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit.
Competitive markets are characterized by four basic conditions: A large number of potential buyers and sellers; product homogeneity; rapid, low-cost dissemination of information; and free entry into and exit from the market. In competitive markets, individual buyers and sellers take the market price of the product as given: They have no control over price. Firms thus view their demand curves as horizontal. The firm’s short-run supply curve is that portion of its short-run marginal cost curve above short-run average variable cost. The long-run supply curve is that portion of its long- run marginal cost curve above long-run average cost. In a competitive equilibrium, firms make no economic profits. Production is efficient in that firms produce at their minimum long-run average cost. Firms in competitive industries must move rapidly to take advantage of transitory opportunities. They also must strive for efficient production in order to survive. Some firms in the industry can employ resources that give them a competitive advantage (e.g., an extremely talented manager). Yet in such
M A N A G E R I A L A P P L I C AT I O N S
Collusion in the Lysine Industry In 2009, Warner Brothers produced a feature film named the “Informant!” that focused on price fixing (based on the
book by K. Eichenwald). Matt Damon portrayed Mark Whitacre, a high-ranking executive at Archer Daniels Midland
Company (ADM). He reported to FBI agents in the 1990s that his employer was engaged in illegal price fixing and
helped them collect evidence by secretly recording company executives negotiating pricing agreements with Japanese
competitors. In 1996, ADM pleaded guilty to price fixing and paid a $100 million fine.
Lysine is an amino acid derived from corn used in swine and poultry feed to promote growth. ADM entered the
lysine market in 1991. Prior to that time, the market had been dominated by two Japanese companies. ADM quickly
gained market share. However, with the competition, the price of lysine fell from about $1.30 per pound to $.60 per
pound. According to Whitacre, ADM executives began discussions in 1992 with their Japanese competitors about how
it would be in their mutual self-interest to collude and fix prices. Collectively, the competitors were forgoing millions
of dollars of profit per month because of the competition among the three companies. Whitacre indicates that a favorite
saying at ADM was (a prominent line in the movie): “The competitor is our friend, and the customer is our enemy.” Whitacre lost his whistle-blower immunity when the FBI discovered that he had committed a multimillion dollar
fraud against ADM. He was sentenced to 10 years in jail and was released from prison in December 2006 after serving
8.5 years. In recent years, he had been employed as the Chief Operating Officer and President of Operations of the
biotech company, Cypress Systems.
Source: Warner Brothers (2009), “The Informant!” (movie).
218 Part 2 Managerial Economics
cases, any excess returns often go to the factor of production responsible for the par- ticular advantage, rather than to the firm’s owners.
Although the competitive model provides a useful description of the interaction between buyers and sellers for many industries, there are others where firms have substantial market power—prices are affected materially by the output decisions of individual firms. Market power can exist when there are substantial barriers to entry into the industry. Expectations about incumbent reactions, incumbent advantages, and exit costs all can serve as entry barriers.
The extreme case of a firm with market power is monopoly, where the industry consists of only one firm. Here, industry and firm demand curves are one and the same. In contrast to competitive markets, consumers pay more than marginal cost and the firm earns economic profits. Output is restricted from competitive levels. With a monopoly, not all the potential gains from trade are exhausted.
Monopolistic competition is a hybrid between competition and monopoly. It is like monopoly in that firms under both market structures face downward-sloping demand curves. Market power comes from differentiated products. Examples include retail shops at malls, gas stations (that differ in location and brand), books, movies, and busi- ness schools. The analyses of output and pricing policies are similar in the two cases. The difference between monopoly and monopolistic competition is that in monopo- listic competition, economic profits invite entry that limits profits.
In oligopolistic markets, only a few firms account for most production. Prod- ucts may or may not be differentiated. Firms can earn substantial profits. How- ever, these profits can be eliminated through competition among existing firms in the industry. To analyze output and pricing decisions in oligopolistic industries, we use the concept of a Nash equilibrium: A Nash equilibrium exists when each firm is doing the best it can given the actions of its rivals. In the Cournot model, each firm treats the output level of its competitor as fixed and then decides how much to produce. In equilibrium, firms make economic profits. However, these profits are not as large as would be made if the firms effectively colluded and posted the monopoly price. Other models of oligopoly yield different equilibria. For instance, one model based on price competition yields the competitive solu- tion in the case of homogeneous products: Price equals marginal cost with no eco- nomic profits. Economic theory makes no clear-cut prediction about the behavior of firms in oligopolistic industries. Economic models must be crafted to fit the specific details of the industry and the nature of the competition. Available evi- dence suggests that in some oligopolistic industries, firms restrict output from competitive levels and hence capture some economic profits.
It is in the economic interests of firms in oligopolistic industries to find ways to co- operate, thereby capturing higher profits. An ostensible motive for antitrust laws is to limit the dead-weight social costs that occur when firms collude on price. Even when firms are free to cooperate, effective cooperation is not always easy to achieve. Indi- vidual firms have incentives to deviate from agreed-on outputs and prices. This in- centive is illustrated by the prisoners’ dilemma. This model highlights incentives that can cause cartels to be unstable. However, firms sometimes can cooperate success- fully when they can impose penalties on noncooperative firms. Cooperation also can be sustained through the incentives provided by long-run, repeated relationships.
While short-run economic profits are possible in all market structures, the overall analysis suggests that most firms will not earn economic profits over the longer run. Firms do not earn long-run economic profits in perfect competition or in the more common structure of monopolistic competition. Absent government fiat, competition,
Chapter 6 Market Structure 219
and technological change makes it hard to maintain monopolies and oligopolistic market power over time. Increases in international trade also can reduce the market power of domestic firms. An important bottom line is that managers should consider potential competition in making decisions in all market structures.
A. Dixit and B. Nalebuff (1991), Thinking Strategically (Norton: New York). G. Stigler (1987), The Theory of Price (Macmillan: New York), Chapter 3. R. Pindyck and D. Rubinfeld (1992), Microeconomics (Macmillan: New York), Chapters 8–13.
6–1. The total and marginal cost of producing Product A are
TC � $1,000 � 2Q2
MC � 4Q
The $1,000 is a fixed cost in the short run, but can be avoided in the long run by shutting
down (going out of business). There is only one possible plant size for this operation; thus
SRMC � LRMC � 4Q in this problem. Derive and graph the firm’s short-run and long-run supply curves (on separate graphs).
6–2. Suppose your firm faces a demand curve of P � 90 � .30Q and the marginal cost of produc- tion is $10 per unit. Find the profit-maximizing output and price. Display this choice graphi-
cally (showing the demand, marginal revenue, and marginal cost curves). Is this outcome on
the elastic, inelastic, or unitary elastic part of the demand curve? What are your profits?
6–3. Genesee and Natural Light are the two sole competitors in the ultra low-end beer market in the Rochester metro area. Both firms have marginal costs of 0 and fixed costs of 200. The
industry demand curve is P � 100 � 0.1Q, where Q � Q1 � Q2 a. Assume the firms compete on quantity (Cournot competition). What is the equilibrium
price and total production in the market? How much profit will each firm make?
b. If firms compete on price (rather than quantity), is the answer in Part A a Nash equilibrium? Explain.
c. Now assume that Genesee acquires Natural Light’s Rochester operations and has a total regional monopoly on ultra low-end beer. What price will they charge? How much
profit will the combined firm make? Is this more or less than in Part A? Explain briefly
why you found what you did.
d. Now suppose that neither firm has entered the Rochester market and that it costs $10,000 to build a plant. Suppose that Genesee spends $10,000 to build a plant and
starts producing 400 units. Will Natural Light want to spend $10,000 to enter the mar-
ket? Show why. Assume that there is only one production period to consider.
Solutions to Self-Evaluation Problems 6–1. The firm’s short-run supply curve is the portion of its short-run marginal cost curve that lies
above average variable cost (AVC). AVC is VC�Q � 2Q2�Q � 2Q. SRMC, which is 4Q, is everywhere above 2Q. Therefore the firm’s short-run supply curve is P � 4Q:
P
Q 1
$4
SR supply
Self-Evaluation Problems
Suggested Readings
220 Part 2 Managerial Economics
The firm’s long-run supply curve is the portion of its long-run marginal cost curve that lies
above long-run average total cost (LRAC). LRAC in this problem is
LRAC � TC�Q � $1,000�Q � 2Q
Recall that LRAC falls when LRMC is below it and rises when LRMC is above it.
LRAC is minimized when it equals marginal cost. This is the point where positive supply
begins (the firm stays in business), since its LRMC is above LRAC at every quantity
beyond this point. The point can be found by setting LRAC � LRMC and solving for Q and LRMC:
$1,000�Q � 2Q � 4Q $500 � Q2
Q � 22.36 units
At this quantity LRMC � LRAC � $89.44. At this price the firm breaks even (TR � TC). At lower prices the firm loses money and in the long run it is optimal to shut down. Thus the firm’s long-run supply is 0 up to a price of $89.44 and is P � 4Q at higher prices:
6–2. Profit maximization occurs where MR � MC. The MR function has the same intercept as the linear demand curve but twice the negative slope. Therefore the profit-maximizing con-
dition is
90 � .60Q � 10.
Solving this equation produces the profit-maximizing quantity, Q* � 133.33 units. The op- timal price (from the demand curve) is $50. The firm makes a profit of $40 per unit for a
total profit of $5,333.20. The outcome is on the elastic portion of the demand curve (above
the midpoint on the linear curve). It is never optimal for a firm to produce on the inelastic
portion of its demand curve since revenue is increased and costs reduced by lowering out-
put. The graph for this problem is
$/unit
133.33 Q
MC
Demand
MR
$90
$50
$10
P
$89.4
22.36 Q
LR supply
LRAC
Chapter 6 Market Structure 221
6–3. a. In Cournot competition, each firm maximizes its own profits taking the other firm’s out- put as given. In the equilibrium, both of the firm’s expectations about the other firm’s
output are realized. The profit-maximizing conditions for the two firms are
MR1 � (100 � .1Q2*) � .2Q 1 � 0 (optimal condition firm 1)
MR2 � (100 � .1Q1*) � .2Q 2 � 0 (optimal condition firm 2)
The equilibrium occurs at quantities that jointly satisfy these two equations. In this prob-
lem, both firms are identical. Thus in equilibrium Q1* � Q2*. Substitute this relation into either of the two equations to produce a single equation with one unknown variable.
Using the first equation:
(100 � .1Q1*) � .2Q1* � 0
Q1* � 333.33 units � Q2*
Total production (Q1* � Q2*) � 666.66 units. The equilibrium price from the industry demand curve is $33.34. Each firm makes profits of ($33.34 � 333.33) � $200 � $10,913.22.
b. No, the solution in Part A is not a Nash equilibrium if the firms compete on price. In a Nash equilibrium, each firm is choosing optimally given the choice of the other firm. If
one firm chooses a price of $33.34, the other firm would do better by undercutting the
price and capturing the entire market. For example, if firm 1 cuts its price by $1 to
$32.34 it will sell 676.6 units (assuming the other firm does not match the price de-
crease) and make a profit of $21,674.48 (greater than the $10,913.22 in Part A). The
Nash equilibrium with price competition and homogenous products is for both firms to
price at MC ($0 in this problem).
c. After the merger, Genesee is a monopolist. Its demand curve is the industry demand curve. It will maximize profits by setting its MR, 100 � 0.2Q � 0. Q* � 500 units and P* from the demand curve is $50. The firm makes a profit of ($50 � 500) � $200 � $24,800. This profit is higher than the combined profit in Part A ($21,826.44). As a
monopoly, the firm can charge the price (and produce the corresponding quantity) that
maximizes total profits for the industry. Firms make economic profits in the Cournot
equilibrium but their competition (noncollusion) produces an outcome with lower
profits than monopoly.
d. No, Natural Light will not enter. If Genesee is producing 400 units, Natural Light’s de- mand curve is P � (100 � .1 � 400) � .1Q2. Its optimal production (setting its MR � 0) is 300 units and the resulting price will be $30 (given 700 total units are being pro-
duced). Natural Light’s profits are (300 � $30) � 200 � $8,800, which are less than the $10,000 entry fee.
6–1. What four basic conditions characterize a competitive market?
6–2. The short-run marginal cost of the Ohio Bag Company is 2Q. Price is $100. The company operates in a competitive industry. Currently, the company is producing 40 units per period.
What is the optimal short-run output? Calculate the profits that Ohio Bag is losing through
suboptimal output.
6–3. Should a company ever produce an output if the managers know it will lose money over the period? Explain.
6–4. What are economic profits? Does a firm in a competitive industry earn long-run economic profits? Explain.
6–5. The Johnson Oil Company has just hired the best manager in the industry. Should the own- ers of the company anticipate economic profits? Explain.
6–6. A Michigan court ruled in the 1990s that General Motors did not have the right to close a particular Michigan plant and lay people off. Do you think this ruling benefited the people
of Michigan? Explain.
Review Questions
222 Part 2 Managerial Economics
6–7. The Suji Corporation has a monopoly in a particular chemical market. The industry demand curve is P � 1,000 � 5Q. Marginal cost is 3Q. What is Suji’s profit-maximizing output and price? Calculate the corresponding profits.
6–8. Assume the industry demand for a product is P � 1,000 � 20Q. Assume that the marginal cost of product is $10 per unit.
a. What price and output will occur under pure competition? What price and output will occur under pure monopoly (assume one price is charged to all customers)?
b. Draw a graph that shows the lost gains from trade that result from having a monopoly.
6–9. In 1981, the United States negotiated an agreement with the Japanese. The agreement called for Japanese auto firms to limit exports to the United States. The Japanese government was
charged with helping make sure the agreement was met by Japanese firms. Were the Japan-
ese firms necessarily hurt by this limited ability to export? Explain.
6–10. Compare the industry output and price in a Cournot versus a competitive equilibrium. Do firms earn economic profits in the Cournot model? Does economic theory predict that firms
always earn economic profits in oligopolistic industries? Explain. What does the empirical
evidence indicate?
6–11. What is a Nash equilibrium? Explain why a joint confession is the Nash equilibrium in the prisoners’ dilemma.
6–12. Candak Corporation produces professional quality digital cameras. The market for profes- sional digital cameras is monopolistically competitive. Assume that the inverse demand
curve faced by Candak (given its competitors’ prices) can be expressed as P � 5,000 � 0.2Q and Candak’s total costs can be expressed as TC � 20,000,000 � 0.05Q2. Answer the following questions.
a. What price and quantity will Candak choose? b. Is this likely to be a long-run equilibrium for Candak Corporation? Why or why not? If
not, what is likely to happen in the market for professional digital cameras, and how
will it affect Candak?
6–13. Will a monopolist ever choose to produce on the inelastic portion of its demand curve? Explain.
chapter
7 C H A P T E R O U T L I N E
Pricing Objective
Benchmark Case: Single Price per Unit
Profit Maximization
Estimating the Profit- Maximizing Price
Potential for Higher Profits
Homogeneous Consumer Demands
Block Pricing
Two-Part Tariffs
Price Discrimination— Heterogeneous Consumer Demands
Exploiting Information about Individual Demands
Using Information about the Distribution of Demands
Bundling
Other Concerns
Multiperiod Considerations
Strategic Interaction
Legal Issues
Implementing a Pricing Strategy
Summary
I ntuit began as a small software company in 1983 with its new program Quicken—a personal finance program that addressed the common household problem of balancing the family’s checkbook. By 2013, In- tuit had grown to a company with over $4.1 billion in annual revenue
and publicly traded stock on the Nasdaq Stock Market. Its flagship products in 2014 included Quicken, QuickBooks, and TurboTax.
A visit to Intuit’s website in 2014 would have revealed many interesting pricing decisions. Consider the following examples: (1) Intuit offered five Windows versions of Quicken including its Starter, Deluxe, Premier, Home & Business and Rental Property Manager editions. The prices for these prod- ucts ranged from the Starter Edition selling at $39.99 to the Rental Property Manager Edition selling at $164.99. (2) The four higher priced editions could read computer files produced by older versions of Quicken, but the low- priced Starter Edition could not. Thus existing users who wanted to update their software, but use existing data files, had to purchase one of the higher priced alternatives. (3) A Mac version of Quicken was priced at $49.99. (4) Customers who purchased Quicken were offered free shipping and a free mobile app. (5) Online customers could enter a “Special Offer Code” that gave discounts to customers with the code. (6) Intuit provided a
Pricing with Market Power
L E A R N I N G O B J E C T I V E S
1. Explain a profit-maximizing firm’s basic pricing objective. 2. Explain how block pricing and two-part tariffs can sometimes be used to increase
profits when facing homogenous consumers.
3. Define price discrimination and explain how it can sometimes be used to increase profits relative to the benchmark case of a single per-unit price.
4. Develop both cost and valuation-related explanations for real-world examples of apparently similar goods sold at different prices.
5. Explain “personalized pricing” (first-degree price discrimination) and provide examples; discuss the social cost implications.
6. Explain “group pricing” (third-degree price discrimination) and provide examples.
7. Explain “menu pricing” (second-degree priced discrimination) and provide examples.
8. Understand how coupons and rebates are sometimes used to price discriminate. 9. Discuss how product bundling might increase profits and provide examples.
224 Part 2 Managerial Economics
60-day unconditional money-back guarantee on all its Quicken products (essentially allowing consumers to try it out for free). (7) Packages of 50 standard checks were priced at $1.14 per check, while packages of 2,000 checks were priced at only 13 cents per check. (8) Customers could purchase check value packs that bundled checks, envelopes and deposit slips at prices that were up to $70 lower than if the products were purchased separately.
Pricing is a key managerial decision. These examples illustrate some of the com- plexities associated with product pricing. For example, how should managers set their basic prices? Why do firms use coupons and rebates? Why are some customers charged higher prices for the same product than others? Why do firms bundle products? Why do firms offer a line of similar products at different price points? Why would a firm ever give its products away? Why do some firms offer volume discounts?
In this chapter we present a basic analysis of pricing with market power and pro- vide answers to these and related questions. We organize the remainder of the chap- ter as follows: First, we discuss the underlying objective of pricing decisions. Next, we analyze the benchmark case where the firm charges the same price to all cus- tomers. Subsequently, we consider more complex pricing policies. The chapter ends with a brief discussion of several other issues, including multiperiod considerations, strategic interactions, legal and implementation issues.
Pricing Objective A firm has market power when it faces a downward-sloping demand curve. Firms with market power can raise price without losing all customers to competitors. The ultimate objective is to choose a pricing policy that maximizes the firm’s value. We continue with the standard economic analysis in which managers seek to maximize profits over a single period. Although managers actually seek to maximize the pre- sent value of all future profits, if the business setting is expected to be stationary, these problems are equivalent. Later in this chapter, we discuss how concerns about future profits can affect the current pricing decision. Nonetheless, our single-period analysis is a productive place to begin for providing useful insights into pricing decisions.
Figure 7.1 depicts a firm’s demand curve for and its marginal cost of producing the product. The demand curve reflects what consumers are willing to pay for the product. Only in quite special cases is it in the interests of the firm to sell the prod- uct at below marginal cost: It can do better by not producing the product. (Later in this chapter, we examine multiperiod considerations that might prompt firms to set current price below marginal cost.) Thus, the maximum potential gains from trade are given by the shaded triangle. If the firm were to sell the product at marginal cost, all the gains would go to consumers in the form of consumer surplus (assuming a constant marginal cost). Consumer surplus is defined as the difference between what the consumer is willing to pay for a product and what the consumer actually pays when buying it. Profit-maximizing managers try to devise pricing policies that capture as much of the available gains from trade as possible: The managerial ideal would be to capture all the potential consumer surplus as company profit.
We begin by reviewing the benchmark case where the firm charges all customers the same price. In this case (which was introduced in Chapters 4 and 6), the firm cap- tures some, but not all, of the potential gains from trade. Subsequently, we consider more complex pricing policies.
Chapter 7 Pricing with Market Power 225
Benchmark Case: Single Price per Unit
Profit Maximization
Suppose that Intuit sells a software product called Checkware. It pays royalties of $10 per copy to the software developer and selects a retail price to post on the Inter- net. All customers buy at this price regardless of the quantity purchased. Intuit has no other incremental costs and faces the following demand curve:
P � 85 � 0.5Q (7.1)
where P is price and Q is quantity (in thousands of copies). What price should Intuit select to maximize profits? Chapter 6 shows that profits are maximized by selecting a price–output combina-
tion in which marginal revenue equals marginal cost. Marginal revenue is 85 � Q, and marginal cost is $10 in this example.1 Thus the optimal quantity and price are 75,000 and $47.50, respectively. Profits are $2,812,500. Figure 7.2 illustrates the solution graphically.
We focus on this example to offer a number of basic insights. It is important to note, however, that this analysis simplifies the pricing problem in at least four im- portant ways. First, all consumers are charged the same unit price, regardless of the quantity purchased. Thus, more complicated pricing strategies are not considered. Second, the firm sells only one product; thus interactions among products are not considered. Third, the demand curve is for a single period. The analysis focuses on maximizing single-period profits and abstracts from longer-term considerations (e.g., how pricing this period might affect either demand or costs in future periods). Fourth, the demand curve assumes that the prices of competing products are constant no matter what price Intuit charges. In some markets, there is likely to be interaction
MC
$
Q
Quantity
P ri c e (
in d
o lla
rs )
Demand
Figure 7.1 Pricing with Market Power
The demand curve reflects what consumers are willing to pay for the product. It typically is not in the firm’s interest to sell the product below marginal cost, since it can do better by not producing the product. Thus, the maximum potential gains from trade are given by the shaded triangle. The firm’s objective is to select a pricing policy that maximizes its share of the gains from trade and thus firm profit.
1For expositional simplicity, we assume marginal cost is constant; in the more general case, one also requires
information about the marginal cost function.
226 Part 2 Managerial Economics
in the pricing decisions of firms within the industry. Later in this chapter, we con- sider the implications of relaxing these assumptions.
Relevant Costs Managers maximize profits by setting marginal cost equal to marginal revenue. As emphasized throughout this book, sunk costs are irrelevant for the pricing–output decision—only incremental costs matter. Suppose that Intuit previously had spent $100,000 for developing and promoting its website. While Intuit hopes to generate enough profits to offset this initial investment, this expenditure is sunk and hence is irrelevant for its current pricing decisions.
Also as discussed earlier, it is important for managers to focus on opportunity costs, not accounting costs. For instance, suppose that Intuit has some Checkware packages in inventory for which it had paid $18 per copy in royalties (e.g., the contract with the developer could call for an $18 royalty per copy for the first 20,000 copies and $10 per copy thereafter). This historical cost is not relevant for the current pricing deci- sion. Rather what is important is the current cost for replacing the inventory—$10.2
Price Sensitivity Additional insights into a monopolist’s pricing decision can be developed using the concept of price elasticity introduced in Chapter 4. Recall that the price elasticity � is a measure of price sensitivity. The higher the price elasticity, the more sensitive is the quantity demanded to price changes. With some algebra, it is easy to show that the monopolist’s optimal pricing policy of setting marginal revenue equal to mar- ginal cost can be rewritten as
P* � MC*�[1 � 1��*] (7.2)
where P* is the profit-maximizing price, MC* � marginal cost, and �* is the elas- ticity of demand, all at the optimal output level.
MC MR
$
Q
10.00
85.00
47.50
170Q* � 75 P
ri ce
( in
d o lla
rs )
Quantity of Checkware
Demand
P* �
Figure 7.2 Single Price per Unit
The marginal cost of the software is $10. Demand is given by P � 85 � 0.5Q. If the firm charges a single unit price to all customers, profits are maximized by setting marginal revenue (MR � 85 � Q) equal to marginal cost. The resulting optimal price and quantity are $47.50 and 75, respectively.
2Suppose that a package was sold for $16 that originally costs $18. The company reports an accounting loss
of $2. However, if the company has to pay $10 to replace the unit in inventory, it actually has an economic
profit of $6. (When the wholesale price fell from $18 to $10, Intuit lost $8 for each unit in inventory.)
Chapter 7 Pricing with Market Power 227
Recall that the elasticity of demand ranges between 0 (totally inelastic) and q (infinitely elastic). Market power decreases as demand becomes more elastic at the optimal price.
No firm should operate on the inelastic portion of its demand curve (� � 1). To understand why, assume this conclusion is false—suppose the profit-maximizing price is on the inelastic portion of the demand curve. Now consider a price above this profit-maximizing price. With inelastic demand, total revenue increases with an in- crease in price. As price is increased, fewer units are sold and production costs fall. With an increase in revenue and a reduction in costs, profits must increase with price: Hence the maximum profit cannot lie on the inelastic portion of the demand curve. Thus, we are assured that �* � 1, and the optimal price is greater than marginal cost.
If a firm has substantial market power, its demand will be less elastic at the opti- mal price and the markup over marginal cost will be high. In contrast, if the firm has limited market power (e.g., there are many good substitutes), elasticity will be high and the markup low.
In our Checkware example, the markup is $37.50 ($47.50 � $10). The elasticity at the optimal price–quantity combination is 1.27 (using the technique from the ap- pendix of Chapter 4). Figure 7.3 compares this case with that of a more elastic de- mand curve for another software product—Illustrator :3
P � 42.50 � 0.25Q (7.3)
With this demand curve, the optimal output and price are 65,000 and $26.25, re- spectively. The elasticity at this combination is 1.62 compared to 1.27 in the first ex- ample. Correspondingly, the markup is lower ($16.25 vs. $37.50).
$
MC10.00
85.00
42.50
Q* � 65 170
More elastic demand at the optimal price
Quantity of Illustrator
Q
Demand 26.25
MR
$
MC10.00
85.00
47.50
Q* � 75 170
Less elastic demand at the optimal price
Quantity of Checkware
Q
Demand
P ri ce
( in
d o
lla rs
)
MR
P * �
P * �
� � 1.27
� � 1.62
Figure 7.3 Price Sensitivity and Optimal Markup
The optimal price markup above marginal cost depends on the elasticity of demand. The optimal markup decreases with the elasticity of demand at the optimal price/quantity combination. The demand curve for Checkware on the left is less elastic than the demand curve for Illustrator on the right. Correspondingly, the optimal markup is higher for the demand curve on the left ($37.50 above cost versus $16.25 above cost). At the optimal price and quantities, the elasticity for the demand curve on the left is 1.27 versus 1.62 for the demand curve on the right.
3For both demand curves, the quantity sold is 170 when price is zero; however, quantity declines more rapidly
with price increases in the second case.
228 Part 2 Managerial Economics
Estimating the Profit-Maximizing Price
Economic theory suggests that managers should price so that marginal revenue equals marginal cost. One practical problem in applying this principle is that managers often do not have precise information about their demand curves and thus their marginal revenue. Thus, depending on the circumstances, policies like cost-plus or markup pricing (discussed below) can serve as useful approximations or rules of thumb in the absence of better information.
Linear Approximation One technique that can be employed with limited information is the linear approxi- mation method. This method requires that the pricing manager have estimates of the current price, the current quantity sold, the quantity sold if the price is changed (say by 10 percent), and the marginal cost of production.
Suppose in our example that Intuit’s pricing manager, Sally McGraw, currently is pricing the product at $70 and is selling 30,000 units per period. Sally estimates that if she lowers her price by $5 to $65, she will sell 40,000 units. This estimate might be based on knowledge about what competitors are charging for the same product, results from past experiences in altering prices, and so on. This information gives her two points on her demand curve. If she assumes the demand curve is linear, she can solve for it. The estimated slope of the line is (65 � 70)�(40 � 30) � �0.5 (with quantities mea- sured in thousands of units). To solve for the intercept, she would substitute the current price and quantity into the equation for a line (P � a � bQ ) with slope equal to �0.5:
$70 � a � 0.5(30)
Solving for the intercept yields
a � 85
Hence, the estimated demand curve is
P � 85 � 0.5Q (7.4)
Given this estimated demand curve and a marginal cost of $10, Sally has enough in- formation to solve for the “optimal” price. Whether or not this price is close to the true optimal price depends on the accuracy of her cost and sensitivity estimates and on whether the demand curve is close to being linear. Even if the demand curve is not linear, linearity may not be a bad approximation, especially if she begins at a price that is not too far from the optimal price.
In this example, Sally will lower the price from $70 to $47.50. The corresponding change in sales will provide her with additional information, which will be useful for future pricing decisions. For example, was the increase in sales close to what she pre- dicted? If she worries that a $23.50 price reduction is too drastic given her lack of confidence in her estimate of the demand curve, she might start with a smaller price reduction, followed by more reductions if additional experience warrants them. Al- ternatively, she might offer a $23.50 rebate on the purchase price. If the price cut turns out to be a bad idea, she can simply eliminate the rebate (rebates are discussed in greater detail below).
Cost-Plus Pricing One of the more common pricing methods used by firms is cost-plus pricing. Firms that use this technique calculate average total cost and then mark up the price to yield a target rate of return.
Chapter 7 Pricing with Market Power 229
For example, suppose that Sally expects to sell 75,000 units and targets a 20 per- cent return on sales. Total costs include the $10 variable cost per unit and the $100,000 of up-front investment. To solve for the implied price, Sally begins by cal- culating a unit cost:
Unit cost � variable cost � (fixed costs�unit sales) (7.5)
so in this case,
Unit cost � $10 � ($100,000/75,000) � $11.33
The price that will yield the target rate of return is found using the following formula:
Price � unit cost�(1 � target rate of return) (7.6)
In our example, this formula implies a price of $14.16 ($11.33�0.8); the return on sales is ($14.16 � $11.33)�$14.16 � 0.20.
We have stressed how profit-maximizing pricing considers only incremental costs and depends on the price sensitivity of customers. Cost-plus pricing appears to ig- nore both of these considerations. The cost-plus price marks up average total cost and seems to ignore the demand for the product—just because Sally targets a 20 per- cent return on sales does not mean that customers will necessarily buy the product in the required quantities at the implied price.
Firms that consistently use bad pricing policies will find themselves earning lower profits than they could with better pricing techniques and even may go out of busi- ness. But if cost-plus pricing is so unsound, why is it so widely used in the market- place? One explanation is that managers implicitly consider market demand in choosing the target return and the target sales volume. If Sally knows that the prod- uct faces little competition, more units can be sold and a higher return will be chosen than when facing greater competition. Conceptually, there is always some target vol- ume and return on total cost that produces the profit-maximizing price.
In our first example, the optimal price and quantity for Checkware are $47.50 and 75,000, respectively. The corresponding unit cost is $11.33. Using a target return of 76.15 percent in Equation (7.6) will produce the profit-maximizing price of $47.50. If Sally realizes that she has substantial market power with Checkware, she should select a high target return (in this case—76.15 percent). Correspondingly, for prod- ucts where she has less market power, she Checkware, then Sally could choose a tar- get return of 56.84 percent and the implied price would be $26.25.
The idea that managers choose target returns and volumes based on market power when they employ cost-plus pricing is supported empirically. Consider the price markups by a typical grocery store employing cost-plus pricing. Stable products such as bread, hamburger, milk, and soup are relatively price-sensitive and carry low margins (markups of under 10 percent above cost). Products with high margins tend to be those with relatively inelastic demand, such as spices, seasonal fresh fruit, and nonprescription drugs (markups as high as 50 percent or more). One experienced grocery store manager noted that “price sensitivity is the primary consideration in set- ting margins.”4 Cost-plus pricing is more useful when the rate of return that yields the profit-maximizing price on the product is relatively stable over the relevant range of cost variation for a given product and varies little across a set of related products.
4J. Pappas and M. Hirschey (1990), Managerial Economics, 6th edition (Chicago: Dryden Press).
230 Part 2 Managerial Economics
Markup Pricing Many managerial economics textbooks suggest a pricing rule-of-thumb based on Equa- tion (7.2): P* � MC*�[1 � 1��*]. This method—typically referred to as markup pricing—consists of substituting an estimate of the current price elasticity and marginal cost into Equation (7.2) and solving for the optimal price.
Equation (7.2) is a condition that holds at the optimal price–quantity combination. But price elasticity generally varies along the demand curve. If Sally currently is at a suboptimal price–quantity combination, the current elasticity will differ from that at the optimal point. Using the current price elasticity in Equation (7.2) will yield a good estimate of the optimal price only when it is close to the elasticity at the opti- mal price and quantity.
On the Importance of Assumptions In our Checkware example, the underlying demand curve is linear. Unsurprisingly, the linear approximation works well. In contrast, the markup pricing rule does not. If Sally begins at a price of $70 and a quantity of 30,000, then the demand curve (P � 85 � 0.5Q ) implies that the elasticity is 4.66 (this can be derived using the technique from the appendix of Chapter 4). Plugging 4.66 into Equation (7.2) along with the marginal cost of $10 yields an “optimal” price of $12.73. But this is far from the optimal price of $47.50. This illustration highlights the importance of considering the underlying assumptions in choosing among alternative rules of thumb. It is easy to imagine other circumstances where the markup pricing rule yields a better estimate than the linear approximation.
M A N A G E R I A L A P P L I C AT I O N S
Parker Hannifin Increases Profits by Adopting an Economically Sound Pricing Policy Parker Hannifin Corporation is a large industrial parts maker. Throughout much of its century-long history, the
company used a simple cost-plus pricing policy for its 800,000 parts. It calculated how much it cost to make and
deliver each product and added a flat percentage on top, usually 35 percent. This policy was inconsistent with basic
economic theory, which indicates that prices should not be based on just costs. The customers’ willingness to pay
(price sensitivity) also should be considered.
Donald Washkewicz became Parker’s CEO in early 2001. He quickly decided that Parker should “stop thinking like
a widget maker and start thinking like a retailer, determining prices by what a customer is willing to pay rather than
what a product costs to make.” He reasoned that sports teams raise ticket prices if they’re playing a well-known
opponent. Why shouldn’t Parker do the same?
In October 2001, Washkewicz unveiled a new plan, which involved creating a new senior position for pricing and
bringing in outside consultants. In implementing this plan, Parker’s analysts divided its many products into four basic
categories (A, B, C, and D) based on their estimated demand sensitivities. They determined that about a third of
Parker’s products fell “into niches where there was little or no competition or where Parker offered some other unique
value.” Based on this analysis, Parker increased many of its product prices, while lowering the prices of other products
where they faced stiff competition.
Parker’s management believes that this new pricing strategy was a major reason why the company’s operating
income increased by $200 million between 2002 and 2006. From the end of 2002 to April 2007, Parker’s stock price
increased nearly 88 percent, compared to a 25 percent jump in the S&P 500. Parker’s experience highlights how
pricing decisions can have a major effect on profits and value.
Source: T. Aeppel (2007), “Seeking Perfect Prices, CEO Tears Up the Rules” The Wall Street Journal (March 27).
Chapter 7 Pricing with Market Power 231
Potential for Higher Profits
In the benchmark case of a single unit price, the firm captures some, but not all, of the potential gains from trade. Figure 7.4 provides an illustration. Firm profits are displayed by the shaded rectangle, and the associated consumer surplus is the triangle labeled abc. The triangle, labeled def , shows additional potential gains from trade that would accrue from selling to customers who value the product above its marginal cost, but who do not buy the product at the higher unit price P *. Below we discuss how a firm might increase profits through more complicated pricing strategies that allow it to capture some of the gains from trade displayed by these two triangles.
MC MR
$
Q Q*
P ri ce
( in
d o lla
rs )
Quantity of Checkware
Demand
a
b
c
e
d f
P *
Figure 7.4 Potential for Higher Profits
If the firm charges a single unit price, profits are maximized at a price of P* and a corresponding quantity of Q*. The corresponding profits are shown by the shaded rectangle. Consumers receive surplus equal to triangle abc, and triangle def represents unrealized gains from trade (consumers who value the product at more than cost but who do not buy the product because of the high price). The firm can earn higher profits if it can devise a more complex pricing policy that allows it to capture some of the potential profits represented by these two triangles.
M A N A G E R I A L A P P L I C AT I O N S
Microsoft’s Market Power and Pricing In 2001 Microsoft managed to boost sales of its Windows products by 16 percent while worldwide shipments of PCs
fell 4 percent. Windows and Microsoft Office software continue to throw off amazing amounts of cash. Analysts agree
that most customers really don’t have a choice of desktop software. While analysts rarely describe Microsoft as a
“monopoly,” they frequently refer to Microsoft’s “unique market position” or “huge installed base.” Microsoft has
found several ways to raise prices. Microsoft stopped requiring companies to buy individual copies of software for
each employee. It now offers a multiyear site license where one copy of the software can be downloaded to individual
PCs. With multiyear licenses, organizations pay an annual fee to Microsoft to use its software rather than buying
individual copies. Alvin Parks, an analyst with the research firm Gartner Inc., argued that this new pricing policy
“means a price increase for everybody, eventually.” Walter Casey, an analyst at Banc One, says, “They’re trying to
force people to upgrade, [though] maybe they’d say ‘encourage.’”
Source: R. Buckman (2002), “Microsoft Sprints On as Tech Sector Plods,” The Wall Street Journal (August 8), C1–C3.
232 Part 2 Managerial Economics
Homogeneous Consumer Demands Potential customers for a product might have quite similar individual demand curves, or they might vary widely in their demands for the product. For instance, in the Checkware example, all potential customers might be willing to pay the same maxi- mum price for the product. Alternatively, some customers might be willing to pay a high price for the product, whereas others might be willing to buy the product only at a quite low price. We begin our discussion of more complicated pricing strategies by examining the case of homogeneous demands—in the limit they are identical. These same techniques are appropriate where the firm is dealing with a given indi- vidual customer and wants to extract maximum profit. Subsequently, we examine the case of heterogeneous demands.
Block Pricing
The overall demand curve for a product is the sum of individual customer demands at each price. For many products, individual customers are likely to consider purchasing multiple units (consider fruit, clothes, and so on). In the benchmark case, individuals pay the same price per unit independent of the number of units purchased. More generally, the company might charge a given customer different prices per unit, depending on the number of units purchased. Profits sometimes can be increased (even if all customers have similar demand curves) by basing the price per unit on the number of units purchased.5
Individuals have downward-sloping demand curves for products. This implies that the marginal value that a customer places on each additional unit declines as the quan- tity purchased increases. Conceptually, the firm could capture all the potential gains from trade with a customer by charging a price equal to the marginal value of each unit. Thus it might charge $100 for the first unit, $99 for the second unit, $98 for the third unit, and so on (where the prices represent the customer’s marginal value of each addi- tional unit). Practical considerations often will preclude such a pricing policy. How- ever, the policy might be approximated by charging a high price for the first purchase block (e.g., up to 5 units) and declining prices for subsequent blocks. For example, the company might charge the customer $98 per unit up to the first five, $95 per unit for the next five, and so on. As discussed below, block pricing not only is used to extract
ANALYZING MANAGERIAL DECISIONS: Profit Potential for a Microbrewery
You operate a small microbrewery in Germany.
The demand curve for cases of your beer is
P � 50 � .002Q. Your marginal cost for producing beer is 10 euros per case. Currently you are charging
all customers the same price for a case of your beer.
1. What are the optimal price, quantity, and prof-
its under this pricing policy?
2. Calculate the surplus that goes to consumers.
3. Describe how you might capture additional
profits using a more sophisticated pricing pol-
icy that does not involve capturing more of the
consumer surplus. Explain.
5Note that in the following discussion, we assume that a customer cannot buy a large quantity and then resell
it to other customers (undercutting the prices that the company charges to other customers for small
quantities). The importance of this assumption is discussed in more detail below.
Chapter 7 Pricing with Market Power 233
additional profits from a homogeneous customer base, but also is used in certain circumstances to increase profits when customer demands are more heterogeneous.6
Another type of block pricing can occur in the choice of package size. Suppose a typical customer values a first T-shirt at $16 and a second at $10. If vendors sell the shirts individually, they have to charge $10 or less to get a customer to buy two. If they offer them in packs of two at a price of $26, customers will be willing to pur- chase the package and pay an average price of $13 per shirt.
Two-Part Tariffs
With a two-part tariff, the customer pays an up-front fee for the right to buy the prod- uct and then pays additional fees for each unit of the product consumed. A classic ex- ample is an amusement park, where a customer pays a fee to get in and then so much per ride (Disneyland used to price in this manner).7 Golf and tennis clubs, computer information services, and telephone service providers are examples of companies that frequently use two-part tariffs.
The benchmark case of charging one price to all customers is a special case of a two-part tariff. The entry fee is zero and the additional units can be purchased at the quoted price. Making more general use of two-part pricing (charging a positive entry fee and a subsequent usage price) can sometimes increase profits substantially rela- tive to the benchmark case. As we discuss below, this is most likely to be true when potential consumers have relatively homogeneous demands for the product.
M A N A G E R I A L A P P L I C AT I O N S
Block Pricing at Best Buy Best Buy priced Nintendo DS Games during July 2014 in the following manner. A given consumer was charged full
price for the first game ($39.99 for the most popular games), but could purchase a second game at half price. Demand
curves usually slope downward, and it is likely that the typical consumer’s willingness to pay for additional games
declines with the number purchased. Presumably Best Buy believed that by offering the discount for the second game,
it would make higher profits than if it sold all games at full price. For example, if all games were priced at $39.99, Best
Buy would sell only one game to consumers who value the second game at less than $39.99 but more than Best Buy’s
marginal cost (which is presumably less than half the listed price).
Whether half is the optimal discount depends on the typical consumer’s willingness to pay for the second game.
With heterogeneous consumers, Best Buy also should consider the additional profits obtained from selling the second
game at half price to those customers who value it less than the first game versus the lost profits from consumers who
would have been willing to pay full price for two games. This trade-off is not an issue in the case of homogenous
consumers analyzed in this section of the main text. Another consideration, which goes beyond the scope of the simple
analysis in this chapter, is whether giving a discount on a second game today reduces future sales at the full price. For
example, consumers might be willing to buy only one game at full price today. However, after playing it for an
extended time period, they might be willing to pay full price for another game in the future. Apparently, Best Buy
believed that the additional profits from offering the second game at a substantially discounted price were larger than
the lost profits from these additional concerns.
Source: Best Buy, www.bestbuy.com (2014).
6For expositional simplicity, we have assumed that marginal cost is constant. If production, packaging, or
distribution costs decline with volume, price discounts would be offered, even without market power. With
market power, the price reductions will exceed the cost reduction as volume increases. 7W. Oi (1971), “A Disneyland Dilemma: Two-Part Tariffs for a Mickey Mouse Monopoly,” Quarterly Journal of Economics (February), 77–96.
234 Part 2 Managerial Economics
For illustration, consider an example where all consumers have identical demands for the product, P � 10 � Q. Figure 7.5 displays a demand curve for a representa- tive consumer. The marginal cost of producing the product is $1. The potential gains from trade that the firm could capture are shown by the shaded triangle and are equal to $40.50 (0.5 � 9 � 9). Maximum profits can be extracted by charging an up-front fee equal to all the gains from trade (or slightly less) and then charging a price equal to marginal cost, $1. With this pricing strategy, the consumer purchases 9 units. In contrast, if the firm charged a single unit price, the best it could do would be a profit of $20.25 (by setting marginal revenue equal to marginal cost). In this case, the price is $5.50 per unit and the consumer purchases 4.5 units.
Two-part tariffs also can be used profitably when customers’ demands are not identical, but this pricing strategy tends to be less effective the more consumers vary in their de- mands for the product. From a practical or legal standpoint, a company might have to offer the same two-part tariff to all potential customers. Charging a high entry fee allows the firm to extract more surplus from customers who have high demands for the product, but potential customers with lower demands will choose not to purchase. When customers’ de- mands vary widely, it often is best to charge a low entry fee (possibly zero) and then charge a price above marginal cost for use. In this case, given the costs of implementing a two- part tariff (devising the pricing strategy, collecting the fees, and so on), the firm frequently is better off just charging a single price. However, in the next section, we discuss other pricing policies that can increase profits when facing more heterogeneous demands.
Price Discrimination—Heterogeneous Consumer Demands Potential customers often vary materially in their willingness to pay for a product. In our benchmark case, the firm charges the same price to all potential customers. With a heterogeneous customer base, the company can make higher profits if it is able to charge different prices to customers, based on their willingness to pay.
Price discrimination occurs whenever a firm charges differential prices across customers (for a given quantity and quality) based on their willingness to pay—not on differences in production and distribution costs. With price discrimination, the markup or profit margin realized varies across customers. Two conditions are necessary for
MC MR
$
Q
P ri ce
( in
d o lla
rs )
Quantity
Demand
10
1
Q* � 9
P * �
Figure 7.5 Two-Part Tariff
In this example, all potential customers had identical demands. The figure displays a demand curve for a representative consumer, P � 10 � Q. The managerial cost of producing the product is $1. The potential consumer surplus that the firm could capture is $40.50, as shown by the shaded triangle. Maximum profits can be extracted by charging an up-front fee equal to all the consumer surplus (or slightly less) and then charging a price equal to marginal cost, $1. Under such a scheme, the consumer purchases 9 units.
Chapter 7 Pricing with Market Power 235
profitable price discrimination. First, customers must vary in their willingness to pay for a given quantity of the product (demand must be heterogeneous). Otherwise, there is no point in segmenting the market. Second, the firm must be able to identify sub- markets and restrict transfers among consumers across different submarkets. Other- wise, any attempt to charge differential prices to customers will be undercut by resale across the submarkets. One group of consumers can buy at the low price, then resell to the other groups at a price below the firm’s prices to these groups.
Sometimes managers have quite good information about individuals’ product de- mands (which specific customers are willing to pay more for the product). For in- stance, if Andrew Leone has sold automobiles to the same customers on repeated oc- casions, he is likely to have relatively good information about each customer’s price sensitivity. In other cases, managers have poor information about individual product demands. For example, early in his career Andy had less experience and accumu- lated information to differentiate among customers who came to the dealership. But he still might be able to engage in certain kinds of price discrimination with infor- mation only about the range or distribution of customer demands. We begin our
M A N A G E R I A L A P P L I C AT I O N S
Two-Part Pricing for Capital Goods Frequently a consumer buys a capital good from a firm and then purchases another good to obtain the services of the
capital good. For example, Gillette sells razors and razor blades, Hidden Fence installs pet containment systems that
require special batteries sold only by Hidden Fence. This situation is like a two-part tariff. With homogeneous
consumers, profits are maximized by setting the price of the capital good to extract all consumer surplus and pricing
the consumable at marginal cost. With heterogeneous consumers it is typically optimal to charge a lower price for the
capital good and a price above marginal cost for the consumable.
M A N A G E R I A L A P P L I C AT I O N S
Supreme Court Rules in Favor of Selling Imports of Copyrighted Items To price discriminate successfully, a firm must not only be able to identify submarkets with varying consumer
demands, but also must be able to restrict trade among these submarkets. The ability of firms to do this is far from
perfect. Tens of billions of dollars of so-called “gray market” sales occur annually, where genuine products are sold in
the United States after being purchased abroad at lower prices. These sales undercut the higher prices charged by
manufacturers in the United States. Walmart and Costco participate in this market by selling gray-market products at
substantial discounts. Many gray-market sales are also made through eBay (the operator of the world’s largest online
marketplace). According to a 2009 Deloitte analysis, imports of gray-market products to the U.S. cost manufacturers as
much as $63 billion in sales a year.
The willingness to pay for textbooks varies significantly across countries around the world. Publishers typically
charge much higher prices for textbooks in the United States than abroad. In 2013, the U.S. Supreme Court considered
an appeal of a $600,000 jury award against a graduate student who had imported John Wiley & Sons textbooks from
his native Thailand, and sold them in the United States for a profit. The case was widely considered to be of great
importance due to the size of the gray market.
The Court ruled in a 6-3 decision that manufacturers cannot block imports of copyrighted items made and sold
abroad. The $600,00 jury award, which had been imposed on the graduate student, was overturned. This ruling makes
it more difficult for publishers and other companies to price discriminate between United States and foreign customers,
thus bolstering the multibillion dollar gray market for products produced by U.S firms.
Source: G. Stohr (2013), “Costco Scores Win Supreme Court Ruling on Imports of Copyrighted Items,” Seattle Times ( March 19)
236 Part 2 Managerial Economics
examination of price discrimination by considering the case where the manager has good information about individual demands. We then consider the case where the manager has information only about the distribution of demands.
Exploiting Information about Individual Demands
Personalized Pricing8
Suppose there are many potential customers. Each customer places a value on the product that signifies the maximum that that individual would pay for the product— their reservation price. For simplicity, suppose each customer purchases at most 1 unit. Personalized pricing ( first-degree price discrimination) extracts the maxi- mum amount each customer is willing to pay for the product. Each consumer is charged a price that makes that customer indifferent between purchasing and not purchasing the product. In this case, the firm extracts all the potential gains from trade. This extreme form of price discrimination is rare and typically is possible only when the number of customers is extremely small and resale is impossible. With per- sonalized pricing, the firm sells to all customers who are willing to pay more than the marginal cost of production. All gains from trade are exhausted, and the outcome is efficient. All the gains from trade, however, go to the firm.
While perfect personalized pricing is rare, new technologies are making it easier for companies to customize quoted prices. For example, companies selling over the Inter- net can vary quoted prices based on past buying histories, demographic information obtained through electronic registration, clickstreams, and so on. Similarly, companies that sell through catalogs can—and often do—include personalized inserts, where the quoted prices vary depending on the customer’s buying history and personal character- istics (e.g., zip code). This type of personalized pricing was more difficult under older printing technologies and before the existence of computerized databases that store customer information.9 Salespeople might also vary product offerings and prices based on a customer’s attire. For example, some wine stewards suggest more expensive wines (with higher price markups) to customers who wear expensive shoes and/or watches.
M A N A G E R I A L A P P L I C AT I O N S
Tuition Pricing Firms engaging in personalized pricing strive to extract the maximum willingness to pay from each customer. While
colleges and universities do not engage in perfect personalized pricing, they effectively charge different prices to
students for tuition through the use of financial aid packages. Stated tuition is the maximum price that any student is
charged. Low-income students, who are likely to be relatively price-sensitive, typically are offered more financial aid
than high-income students. In addition, top students who are likely to have numerous scholarship offers, and thus more
options, are offered significant discounts. An average student from a high-income family typically pays much higher
effective tuition than other students.
8Economists often categorize price discrimination as first-, second-, or third-degree. These terms were
originated by A.C. Pigou (1950), The Economics of Welfare (Macmillan: London). Unfortunately, they are not very descriptive. Following C. Shapiro and H. Varian (1999), Information Rules: A Strategic Guide to the Network Economy (Harvard Business School Press: Boston), we use more descriptive terms like personalized pricing, menu pricing, and group pricing.
9Note, however, that the Internet also lowers information costs and that this makes market segmentation
(a necessary aspect of effective price discrimination) more difficult (recall the earlier Managerial Application
on made-for-export cigarettes).
Chapter 7 Pricing with Market Power 237
Group Pricing Managers sometimes can gauge an individual’s price sensitivity by observing a char- acteristic of the individual such as age or country of residence. In these cases, the manager can have a fairly good idea of a specific individual’s demand for the prod- uct, even if the manager never has interacted with the customer.
Group pricing (third-degree price discrimination) results when a firm separates its customers into several groups and sets a different price for each group, based on the willingness to pay of the typical group member. For example, utility companies charge different rates to individual versus commercial users, computer companies give educational discounts, and airlines charge different rates based on the amount of notice given for the reservation. Beyond.com charged government agencies and large companies lower prices than other customers. As illustrated in the following example, a firm that can segment its market maximizes profits by setting marginal revenue equal to marginal cost for each market segment.
Firms use a variety of characteristics to divide customers into groups. Three prominent examples are age, time of purchase, and income. For instance, movie
M A N A G E R I A L A P P L I C AT I O N S
Pricing of Books Firms divide customers into groups based on various characteristics. Different prices are charged to each group,
depending on their elasticity of demand.
One characteristic used by book publishers to segment the market is time. When a new book comes to market, it
usually is offered only in a hardcover edition for a relatively high price. Subsequently, it is offered in paperback at a
substantially reduced price. Individuals who have a high demand for the book (and thus a low-price elasticity) do not
want to wait for the paperback edition and thus pay a high price for the book. Those with lower demands wait for the
cheaper edition. After the paperback edition comes to market, the publisher generally will continue to offer the
hardcover edition. Hardcover books are likely to make better gifts than paperbacks. Also customers are likely to prefer
hardcovers for their libraries. Thus there continues to be a market for both types of books. Continuing to offer multiple
versions is an example of menu pricing (discussed below).
In 2014, Amazon.com offered several versions of Harry Potter and the Deathly Hollows by J. K. Rowling—Book 7 in the popular series. The hardcover version sold for $22.46, whereas the paperback sold for $9.81. In addition, there was
a paperback, large-print edition for $10.31, an audio CD for $49.97, and a Kindle Edition for $9.99. The hardcover and
paperback editions also could be purchased as part of specially boxed book sets. When each of the seven Harry Potter
books was originally introduced, it was available only in relatively expensive hard-copy and audio editions.
M A N A G E R I A L A P P L I C AT I O N S
Virtual Vineyards Virtual Vineyards offers premium wines and specialty foods—such as El Serpis Anchovy Stuffed Olives and Fox’s
Fine Foods Killer Corn Relish—over the Internet. The company also offers advice, monthly wine programs, and a
variety of other services at its Web site. Virtual Vineyards tracks the clickstream of each user and instantaneously
makes special offers based on the behavior. In a similar vein, Amazon.com tracks the purchases of each consumer and
recommends additional related books the next time the user logs on. The Internet has made possible many marketing
opportunities not available through other media.
Source: C. Shapiro and H. Varian (1999), Information Rules: A Strategic Guide to the Network Economy (Harvard Business School Press: Boston).
238 Part 2 Managerial Economics
theaters frequently give discounts to senior citizens and students, price lower for matinees than for evening performances, and vary prices across locations depending on the average income in the area. The objective is to charge a higher price to the groups who are willing to pay more for a given quantity of the product.
Consider the Snowfish Ski Resort, which can separate its demand into local skiers and out-of-town skiers. The marginal cost of servicing a skier of either type is $10. Suppose the resort faces the following demand curves:
Out of town: Q0 � 500 � 10P (7.7) Local: Q1 � 500 � 20P (7.8)
Total demand at any one price is the sum of the demands for the two types of consumers:10
Q � 1,000 � 30P (7.9)
If the company sells all tickets at one price, profit maximization will occur at11
P* � $21.66; Q* � 350; Q*0 � 283; Q*1 � 67; Profit � $4,081
The company can make higher profits by charging different prices to the two sets of skiers. The optimal prices are found by setting the marginal revenue equal to the marginal cost in each of the two market segments. Under this pricing policy, the fol- lowing prices, quantities, and profits are observed:
P*0 � $30; Q*0 � 200; P*1 � $17.50; Q*1 � 150; Profit � $5,125
where P*0 and P*1 � prices charged to out-of-town and local skiers, respectively. The resort charges higher prices to the out-of-town skiers, who are less sensitive to ticket prices than local skiers.
Figure 7.6 displays the optimal pricing policy for each market segment. Snowfish treats the two markets as separate and charges the optimal monopolistic price to each segment. Consistent with Equation (7.2), the optimal markup is lower in the more price-sensitive local market. Using the point-elasticity formula developed in the ap- pendix to Chapter 4, it can be shown that at the optimal prices, the elasticities for the local and out-of-town skier markets are 2.33 and 1.5, respectively. The respective markups above marginal cost are $7.50 and $20 (given the prices of $17.50 and $30).
There are a number of methods that Snowfish might use to charge the two groups different prices. Discount coupons might be sold at supermarkets away from major resort hotels. Presumably, most of the sales at these supermarkets will be to local customers. Alternatively, discount books of tickets (nontransferable) could be sold locally prior to the start of ski season. Ski resorts use both techniques. These policies are more profitable the more difficult it is for out-of-town skiers to buy the tickets at prices less than $30.
10This demand curve assumes that price is lower than or equal to $25. At higher prices, the local skiers purchase
no tickets and the total demand curve is simply the demand curve for out-of-town skiers (Q � 500 � 10P ). 11The reader should know by now that the solution to this problem is found by setting marginal revenue equal
to marginal cost and solving for Q*. Price can then be found from the equation for the demand curve. For instance, the total demand curve can be obtained by rearranging Equation (7.9): P � 33.33 � 0.033Q. When the tickets are sold at one price to all consumers, the marginal revenue is MR � 33.33 � 0.067Q. Since marginal cost is $10, the optimal quantity is 350; price is $21.66. The optimal prices and quantities for the
individual market segments are found by completing similar calculations using Equations (7.7) and (7.8).
Chapter 7 Pricing with Market Power 239
Using Information about the Distribution of Demands
In some settings, the manager does not have enough information to divide customers into meaningful groups. For instance, even if a retailer knows that low-income indi- viduals are more price-sensitive than high-income individuals, the retailer may not be able to gauge the incomes of customers when they come to the store.12 Nonetheless, the manager might have enough information about the range or distribution of indi- vidual demands to engage in profitable price discrimination. In this section we discuss two prominent methods that can be used in this setting. Both rely on the principle of self-selection. Consumers are provided with options. They then reveal information about their individual price sensitivities by their choices.
Menu Pricing With menu pricing (second-degree price discrimination), all potential customers are offered the same menu of purchase options. The classic example involves block pric- ing, where the price per unit depends on the quantity purchased.13 For instance, cellular phone companies typically give customers a choice among several rate plans, where the price per minute varies with the minimum number of minutes per month specified across each plan. Customers use their private information about likely usage to select the best rate plan for themselves. By carefully constructing the menu of options, the company makes more profits than if it simply offered the prod- uct at one price to all potential customers (e.g., offering phone service at $.10 per minute, independent of volume). If such quantity discounts are based solely on costs,
$
MC 10.00
50.00
25.00
Q* � 150
Quantity of passes for local skiers
Q
P * �17.50
MR
$
MC10.00
50.00
30.00
Q* � 200
Quantity of passes for out-of-town skiers
Q
�* = 1.50
P ri ce
( in
d o
lla rs
)
MR
�* = 2.33 P * �
Figure 7.6 Optimal Pricing at Snowfish Ski Resort
Snowfish can segment its customers into two market segments, out-of-town skiers and local skiers. The marginal cost of serving either type of skier is $10. The optimal pricing policy is to set the monopoly price in each market segment. The markup is higher for out-of-town skiers because they have less elastic demands than local skiers. At the optimal prices ($30 and $17.50), the demand elasticities are 1.50 for out-of-town skiers and 2.33 for local skiers.
12Also it may be neither practical nor legal to charge customers different prices for the same products even if
the retailer were to know each customer’s income. 13Recall that block pricing can be used to increase profit either by extracting more profits from a given
homogeneous customer population or by increasing profits through charging different prices to high- versus
low-volume customers. In this section, we discuss the second use.
240 Part 2 Managerial Economics
then there is no price discrimination. However, large-quantity users have incentives to search and thus are likely to be more price-sensitive than low-quantity users, and thus block pricing allows different rates to be charged to the two groups even if per- unit costs are similar. Public utilities frequently price in this manner.
A related pricing strategy is to offer potential customers a menu of price–quality combinations. For instance, TurboTax markets both a Premier and Starter version of its software. The Premier version contains additional features that are likely to ap- peal to sophisticated users. The marginal costs of producing and distributing both versions are virtually equal. However, the company marks up the Premier version more because the typical customer choosing this version is likely to be less price- sensitive than the typical customer choosing the Starter version.
Table 7.1 presents a numerical example of menu pricing. Here the market for TurboTax software is divided into two types of users, sophisticated and unsophisti- cated. The reservation prices (maximum willingness to pay) for the Premier and Starter versions are given for both types of users. The marginal cost of producing the software is assumed to be zero.
Ideally, the company would like to identify the two types of users prior to purchase. Assuming it could prevent reselling the software among consumers, the company would maximize profits by charging $100 to the sophisticated users, who would pur- chase the Premier version, and $30 to the unsophisticated users, who would purchase the Starter version. This pricing strategy is equivalent to personalized pricing.
Since the company cannot identify the type of user prior to purchase, it prices the Starter version at $30 and the Premier version at just below $85 (e.g., $84.99). The cus- tomers, who know their own type, choose the quality–price combination that maxi- mizes their individual consumer surplus. Unsophisticated buyers purchase the Starter version (which yields no consumer surplus). Sophisticated users buy the Premier ver- sion and gain a surplus of just over $15 (the surplus they would enjoy if they purchased the Starter version). The potential for the sophisticated buyer to purchase the lower- quality product limits the price that can be charged for the Premier version. If the Pre- mier version were priced above $85, sophisticated users would obtain greater consumer surplus by buying the Starter version at $30, and no Premier versions would be sold.
The end result is that the sophisticated user gains some consumer surplus and the company makes less profit than it would if it could engage in either personalized or group pricing. Nonetheless, it does better than if it offered only one version at a single
Sophisticated Unsophisticated User User
Starter edition $45 $30 Premier edition $100 $30
Table 7.1 Example of Menu Pricing
In this example, there are two versions of TurboTax and two types of users. The table shows the maximum price that customers in each group are willing to pay for the product (reservation prices). The marginal cost of producing both versions is zero. With menu pricing, the firm will price the Starter version at $30 and the Premier version at $85 (or just below). Consumers acting to maximize consumer surplus will self-select. Sophisticated users will buy the Premier version (surplus of $15) and the unsophisticated users will buy the Starter version (surplus of zero). Unlike personalized pricing, the firm does not obtain all the gains from trade. The firm would like to charge more for the Premier version. However, if it does, the sophisticated user will purchase the Starter version.
Chapter 7 Pricing with Market Power 241
price. For instance, the company could offer just the Premier version at a price of $100 and sell only to sophisticated users or offer the product at $20 and sell to both types of users. But it generally is more profitable to offer both quality-price combinations.14
Coupons and Rebates Firms frequently use coupons in product pricing. For instance, most Sunday papers contain numerous coupons offering discounts to customers who use the coupons be- fore their expiration dates. Coupons also are distributed through direct mailings, product packages, and magazines.
Firms also frequently offer rebates, where the customer using the rebate is re- funded some portion of the purchase price. For instance, automobile manufacturers often offer significant rebates (e.g., $1,000) to customers who purchase cars during the rebate period. Software manufacturers and retailers (e.g., Microsoft and Intuit) frequently offer rebates for their products. Rebate offers regularly are attached to products sold at grocery stores.
Coupons and rebates give price discounts to customers. Price discounts in turn might be given to attract new customers (new first-time users or brand switchers) or to increase sales among current customers. Price discrimination is one primary reason why some firms use coupons and rebates to make price discounts rather than simply lowering the price.
Coupons have to be clipped and brought to the store, whereas rebates often re- quire customers to complete and mail rebate forms to the manufacturer. Many cus- tomers do not use available coupons or rebates to purchase products because the money saved through using the coupon or rebate is less than the value of the time it
ANALYZING MANAGERIAL DECISIONS: Cell Phone Pricing
You are a pricing manager for a cell phone com-
pany. You have two types of customers with differ-
ent demand curves for your service. The demand
curves for an individual customer from each group
for hours of talk time per month are
Type A customer: P � 10 � 2Q
Type B customer: P � 10 � Q
Your marginal cost for providing hours of phone
service is zero (all your costs are fixed). There are
1,000 customers of each type.
You know the demand curves for the two types
of customers. However, it is impossible for you to
identify when a person purchases a plan whether
the customer is from one group or the other.
1. Design a menu plan that extracts all of the
consumer surplus from the Type A customers
and as much as possible from the Type B cus-
tomers given that they have the option to pur-
chase your first plan (it might help to graph
the problem). Each of the plans on the menu
must offer a maximum number of hours of
talk time per month for a fixed monthly fee.
(Hint: You can extract all the consumer surplus from the Type A customers using a two-part
tariff. Such a plan can be expressed in terms
of offering a fixed number of minutes at a
fixed price.)
2. What are the total profits from offering the two
plans?
3. What happens if you increase the monthly fee
for the plan designed for the Type B
customers? Explain.
14If the number of sophisticated users is large relative to the number of unsophisticated users, it might be better
to price the deluxe version at $100 and sell only to sophisticated users.
242 Part 2 Managerial Economics
takes to search for and redeem the offer. The typical coupon/rebate user is likely to have a relatively low opportunity cost of time (e.g., the user might not work outside the home or have a low income); such consumers are likely to be more price- sensitive. Thus, issuing coupons and rebates is one way of lowering effective prices to potential customers with more elastic demands.15
In 2008 Intuit offered a $10 rebate to existing customers for the Windows version of Quicken Deluxe (along with a $20 price reduction). Customers who applied for the rebate paid a net price of $29.99, whereas a customer failing to use the rebate paid a price of $39.99. Customers failing to redeem a $10 rebate presumably place a high value on their time and are unlikely to be very price-sensitive.16 Consistent with the principles of price discrimination, they pay a higher price for the product than the more price-sensitive rebate user.
Coupon/rebate programs can be expensive. For instance, there are the costs of de- signing the promotion, printing and circulating the offer, and handling the redemp- tions. These costs can be significant and should be compared with the benefits in choosing whether to offer the program. We have indicated that one of the potential benefits of these programs is increased profit through price discrimination. Another potential benefit is the increase in future profits from new customers who start using the product due to the sales promotion—if they like the product, they might purchase it in the future even if a coupon is not offered.17 Coupons (e.g., in newspapers and magazines) sometimes can be viewed as a form of advertising that lowers informa- tion costs about the product.
Interestingly, some retail companies have offered rebates for the Windows version of a program while offering no rebate for the Mac version. Mac users typically have fewer software products to choose among than Windows users. Also, local software retailers are likely to carry a smaller inventory of Mac products than Windows products. The lack of available substitutes implies that the typical Mac customer is likely to be less price-sensitive than the typical Windows customer. Beyond.com thus offered coupons to Windows users with their higher price sensitivity, and no coupons to the less price-sensitive Mac users. Finally, if Macs are less likely to exist in the future than Windows-based machines, the benefits of attracting new customers for future sales are lower for Macs.
Bundling To this point, we have considered the case where the firm sells a single product. This section extends the analysis by providing an introduction to the case of multiple products.18
15Price discrimination is unlikely to explain the use of large rebates or coupons. For instance, if an automobile
company offers customers a $2,000 rebate, it reasonably can forecast that all customers will take advantage
of this offer. Thus rebates are essentially equivalent to giving all customers a price reduction, for example,
by having a sale. Rebates, however, often are offered by the manufacturer who does not have direct control
over the retail price. For a more extensive discussion of coupons, rebates, and other sales promotions see
R. Blattberg and S. Neslin (1990), Sales Promotion: Concepts, Methods, and Strategies (Prentice Hall: Englewood Cliffs).
16Alternatively, customers might be purchasing the product on the behalf of their companies. In this case,
since the company is paying the bill, the customer might be less price-sensitive. 17Sometimes this benefit can be obtained simply by lowering the purchase price (e.g., by having a sale). 18The topic of pricing multiple products can be relatively complex. Our intent here is to provide a basic
introduction to the idea of product bundling. For a more detailed analysis, see J. Long (1984), “Comments
on ‘Gaussian Demand and Commodity Bundling,’” Journal of Business 57, S235–S246.
Chapter 7 Pricing with Market Power 243
M A N A G E R I A L A P P L I C AT I O N S
Bundling Videogames Microsoft is in a battle with Sony Corp. over videogames. Microsoft is bundling a limited edition Xbox packaged
with Microsoft’s Halo (a shooting game) for $169. Halo is one of the most popular titles exclusive to the Xbox,
and Microsoft expects that this offer will spur sales of the game machine itself.
Source: R. Guth (2004), “Game Gambit: Microsoft to Cut Xbox Price,” The Wall Street Journal (March 19), B1.
Companies frequently bundle products for sale. For example, in 2014 Microsoft offered Microsoft Streets and Trips as a bundle for $39.95.19 This bundle combined leading street-mapping and trip-planning technologies into a single package. Other examples include retailers bundling free parking with a purchase at their store, news- papers selling advertising in both morning and afternoon editions at one price, sea- son tickets for sporting events, and restaurants offering fixed-price complete dinners.
One reason for bundling products is to extract additional profits from a customer base with heterogeneous product demands.20 For example, Table 7.2 presents two types of potential customers: consumers and professional users. The figure displays the maximum prices (reservation prices) that the individual customers within each group are willing to pay for Microsoft Streets and Microsoft Trip Planner. The mar- ginal cost of producing either product is assumed to be zero (to simplify the discus- sion). Potential customers purchase a product only if their surplus is nonnegative.
Why would the company bundle the products, forcing customers to purchase both in order to obtain either? If the firm did not bundle, the most it could charge for Streets would be $15 and for Planner $20 if it wanted to sell to both groups of cus- tomers. Using this policy, it would collect $35 from each customer. The company,
Microsoft Microsoft Streets Trip Planner Bundle
Consumer $15 $25 $40 Professional $30 $20 $50
Table 7.2 Product Bundling
In this example, there are two types of customers, professionals and ordinary consumers. The table shows the reservation prices for Microsoft Streets and Microsoft Trip Planner. The reservation price for the bundle for any consumer is the sum of the reservation prices for the individual products. If the firm wants to sell both products to both types of customers, it must price the products at $70 and $60, respectively (the minimum reservation prices for each product). It collects $130 from each customer. It can do better by selling the products in a bundle for a price of $150 (the minimum reservation price for the bundle). Bundling increases profits in this example because the two groups have opposite relative valuations of the two products. Professionals are willing to pay more for Streets than consumers, while the opposite holds for Trip Planner. Thus, the minimum reservation price for the bundle is greater than the sum of the minimum reservation prices for the separate products.
19Microsoft has sold this product for many years but announced that it would be discontinued at the end of 2014. 20Products also might be bundled to reduce packaging costs or to reduce the costs to customers who want to
buy the products together. For example, to the extent that most users want to utilize features of both street
mapping and trip planning, the technologies might be combined to lower the costs to the customer of
obtaining and integrating the two products.
244 Part 2 Managerial Economics
however, can bundle the products and sell to all customers at a price of $40 (the min- imum reservation price for the bundle).
In this example, the two groups have opposite relative valuations of the two prod- ucts. Professional users are willing to pay more for Streets than consumers, whereas consumers are willing to pay more for Planner than professional users. This feature implies that the minimum bundle value is greater than the sum of the minimum reser- vation prices for each product. Thus, the firm makes more money selling the bundle than selling the products separately. If one group valued both products higher than the other group, there would be no gains from bundling (the minimum bundle value would be the same as the sum of the minimum individual reservation prices).
Typically, products are not just sold in bundles. Often firms use a tactic of optional (mixed) bundling, where the products can be purchased separately or in a bundle at a price below the sum of the individual prices. Optional bundling can be more profitable than pure bundling when some customers value one product highly, but value the other product below the marginal cost of production. For these customers, the extra revenue the firm would earn from selling the bundle would be lower than the extra cost of producing it.
Other Concerns
Multiperiod Considerations
Future Demand In 2008 Intuit offered a free edition of TurboTax. If the objective is to maximize single-period profits for a single product (as in the benchmark case), it is never optimal to set a price of zero.21 Managers, however, are concerned with sales not only in the current period but in future periods as well. Giving the product away can attract
21Firms that sell multiple products can have incentives to price selected individual products below marginal
cost. For example, McDonald’s sometimes has promotions that sell hamburgers at below cost. The intent is
to attract customers who buy other products, such as fries, at prices substantially above cost.
M A N A G E R I A L A P P L I C AT I O N S
Harry Potter: An Example of Price Discrimination In 2010, Sears.com offered a set of Harry Potter DVDs for around $55 plus shipping—approximately $10. A customer
could obtain a rebate form online and mail it in for a rebate of the shipping costs. Why not simply sell the DVDs for
$55? Wouldn’t costs be avoided? For example, it is expensive to issue and mail checks and print posters and coupons.
To illustrate the potential benefits of the policy, suppose that if the DVDs were sold at the same price to all
customers, Sears.com would have priced them at $65. With this policy, Sears.com would lose the potential profit from
selling to consumers who are willing to pay a price above Sears’ production cost but less than $65. Sears’ apparent
objective was to find a way to sell to these consumers at a lower price without having to lower the price to other
consumers. One way to accomplish this objective was through rebates. Presumably, those willing to purchase at $65
had higher opportunity costs for their time (on average). This made them less likely to fill out and mail in the coupons.
Customers not using the rebates paid a price of $65, whereas the customers using the rebate coupons paid $55.
There are a variety of issues to consider in deciding on such a rebate program. First, there is a trade-off between the
costs of administering the program and the benefits of additional sales. Also, there is the loss of $65 sales to customers
who would have purchased at $65 but now use the rebate coupons.
Chapter 7 Pricing with Market Power 245
new customers; it lowers the full cost of consuming the good below that of competing products. If they like the product, they will purchase the product in the future at posi- tive prices. This is a major reason why firms provide “free samples” of their products.
Offering a product at a price below marginal cost is a more effective pricing strat- egy if information costs are higher. If a customer takes the time to learn to use a new software product (such as TurboTax), the customer often will want to continue to use the program in the future, rather than take the time to learn to use a new product. Thus at similar prices, the customer is more likely to buy upgrades and future edi- tions of the current software rather than switch to a competing product. This lock-in effect is a reason why some software firms give away their products (or charge low prices) in the early stages of development.
Firms sometimes charge lower prices than the optimal single-period price because they value maintaining customer goodwill. For example, a severe ice storm in March 1991 produced a major power outage in upstate New York. Electric generators were in high demand and could have been sold to customers at extremely high prices. But local stores did not raise the price of generators substantially. One concern apparently was that they would be seen as taking advantage of customers—that such a tactic would undermine the firm’s reputation and reduce future demand. Drug companies face similar concerns when they price new drugs. These companies have an incentive to charge the profit-maximizing price for their products (to help reimburse them for their development and other costs). However, in setting prices these companies have to consider the reactions of “public-interest” groups and government regulators.
Future Costs As discussed in Chapter 5, for some firms the long-run average cost of producing a given level of output declines as the firm gains experience in producing the product. For instance, employees can gain important information on how to improve the pro- duction process as they gain more experience. When these learning effects are impor- tant, it can be optimal for the firm to produce a high volume of the product initially to gain experience and thus a cost advantage over competing firms in subsequent peri- ods. This high output is correspondingly sold at lower prices than if the firm produced the lower volume associated with optimizing single-period profits.
Many cost advantages, however, are short-lived because competing firms often can copy innovations. Thus managers should consider carefully whether it is appro- priate to adopt such a high-volume, low-price strategy. Chapter 8 discusses this issue in more detail.
Early Use of the Free Sample In 1870, after over 10 years of experimentation, Robert Chesebrough opened a factory in Brooklyn to produce
petroleum jelly. But he initially sold not one bottle. He tried giving samples to doctors and druggists, but they failed to
reorder. Finally, he decided he had to create a market for his salve, so he loaded a wagon full of 1-ounce bottles and
drove around the state giving away samples. When people ran out, they went to their druggist, who then began to place
orders. Chesebrough soon had a dozen wagons canvassing the countryside. As demand continued to expand, Vasoline
made the persistent Chesebrough an extremely wealthy man.
Source: I. Flatow (1992), They All Laughed (Harper Perennial, New York).
H I S T O R I C A L A P P L I C AT I O N S
246 Part 2 Managerial Economics
Storable Products In a number of our examples, we have discussed products that can be stored. This means that sales of the product and consumption of the product are not the same. When you lower the price of a product, the quantity demanded rises for two reasons: First, as demand curves slope downward and as prices drop, there is more consumption; sec- ond, if the price reduction is temporary, the customer will purchase additional units to be consumed at future dates. Thus, for storable goods, the variation over time in sales is greater than the variation in consumption.
Strategic Interaction
The analysis in this chapter starts with a demand curve for the product. Managers choose a pricing strategy that maximizes profits given demand and its cost structure. This approach holds the price of substitute products constant (recall the definition of
M A N A G E R I A L A P P L I C AT I O N S
Market Segmentation The European Commission is trying to forge a single market for drugs across the European union. Bayer, the German
drug maker, was found guilty of striking agreements with French and Spanish wholesalers to dissuade them from
exporting Adalat, a heart treatment, from Spain and France where the price is low, to Britain, where it is 40 percent
higher. The European Court of Justice, Europe’s highest court, ruled that the commission was wrong to fine Bayer for
their actions. This ruling provides Bayer with more flexibility to segregate markets and offer the same product at
different prices.
Source: P. Meller (2004), “Europe Effort to Control Pricing Is Set Back,” New York Times ( January 7), W1.
M A N A G E R I A L A P P L I C AT I O N S
Apple Apologizes for Its Pricing of iPhones Apple Computer provides a good example of how concerns about customer relations and long-term reputation can
affect pricing decisions. In June 2007, Apple and AT&T launched the iPhone at a price of $599. Many iPod aficionados
waited in line for hours to obtain the new, much-hyped phone. Within three months, Apple reduced the price by $200
to $399.
Customers who had purchased the phone at $599 were outraged. Many of these customers had been long-term users
of Macs and iPods. They felt betrayed when “newer, less loyal customers” were able to buy the iPhone at a much lower
price by waiting only a few months. Some of the iPhone purchasers said the timing of the price cut would discourage
them from buying Apple products in the future. “This is like a slap in the face to early adopters,” said John Keck, an
executive at an advertising agency in Detroit. Apple received a flood of negative e-mails. The customers’ strong
reactions were featured prominently in media reports, including the major television networks and newspapers.
In response to this criticism, Apple’s CEO Steve Jobs issued a rare public apology and offered a $100 credit to all
customers who had paid the original price. In a letter posted on Apple’s Web site Jobs’ wrote, “Our early customers
trusted us, and we must live up to that trust with our actions in moments like this.”
If Apple expected to go out of business in the near future, there would be little economic reason to give the credit to
people who had purchased products in the past. Jobs, however, presumably expected Apple to be around for the long
term and that the company must maintain a reputation for being fair and honorable. He was concerned not only about
the current year’s profits, but about future years’ profits as well.
Source: N. Wingfield (2007), “Steve Jobs Offers Rare Apology, Credit for iPhone,” The Wall Street Journal Online (September 7), A1.
Chapter 7 Pricing with Market Power 247
a demand curve). Thus, the reactions of competitors are not considered explicitly in this analysis. Although this approach serves as a useful starting point in many practi- cal applications, it is not as useful in markets with only a few major competitors. In these markets, it often is foolish to ignore rival reactions in setting prices. For exam- ple, if United Airlines offers a major price reduction to customers, it is reasonably safe to assume that the other major airlines (e.g., American Airlines and Delta) will not hold their prices constant. In these situations, it is important for managers to consider explicitly the reactions of rival firms when they price their products. Chapter 9 pro- vides a set of tools (derived from game theory), that is, useful for managers within these interactive settings.
Legal Issues
In addition to factors affecting supply and demand, laws and regulations sometimes limit the firm’s ability to charge different prices to different customers in specific markets. For example, the Robinson–Patman Act limits the ability of firms in the United States to charge retailers different prices unless they can justify the price by showing differences in their costs. (Companies have had considerable difficulty sus- taining a cost justification defense.) Laws in some countries also limit the maximum prices that can be charged for various products. Managers contemplating the pricing policies discussed in this chapter should check the legality of a proposed pricing pol- icy given the laws they face within a particular jurisdiction.
Legal constraints can drive the firm’s choice of pricing policy in a variety of ways. For example, prompted by complaints from local merchants in a college town, the city council passed a law to restrict street vendors from selling hand- crafted items. But the law exempted flower vendors: There was a long-standing tradition of giving flowers to dates before ball games, and local ladies had long supplied the cut flowers. Undeterred, the craft vendors bought bouquets of flowers, placed a flower on each item, and sold the flower with the craft item bundled in for “free.” Some manufacturers in the 1970s began offering rebates rather than cutting product price because when price controls were implemented by the U.S. govern- ment, rebates and price cuts were treated differentially.
Xerox originally leased copying machines with a requirement that the lessee buy Xerox paper; it set the paper price above marginal cost. IBM used a similar pricing plan for tabulation machines and IBM cards. The intent was to extract higher profits from higher-volume users. The government successfully charged
M A N A G E R I A L A P P L I C AT I O N S
Apple Settles Antitrust Case by Lowering iTune Prices in Britain Many forms of price discrimination are legal in countries around the world. Companies, however, can face regulatory
constraints in pricing. On January 9, 2008, Apple Computer settled an antitrust suit by agreeing to cut prices on iTunes
digital music in Britain to align them with those in continental Europe. The European Commission had accused Apple
in spring 2007 of unfairly charging British consumers more than their counterparts in the euro zone for tracks from
iTunes. British consumers had been paying about $1.55 per song, while other European consumers were paying about
$1.46 per song. Under the settlement, all the European customers will be charged the same price.
Source: E. Pfanner (2008), “Apple to Cut the Prices of iTunes in Britain.” nytimes.com (January 10).
248 Part 2 Managerial Economics
both companies with employing illegal tying arrangements. These companies could have achieved the same result with less legal exposure. Rather than sell paper and punch cards at prices above cost, they could have offered these items at marginal cost and rented the machines with a two-part price—a fixed amount per month plus so much per copy or card read.
Implementing a Pricing Strategy In this chapter we have provided a basic introduction to product pricing. We have discussed the objective of pricing decisions, presented a basic economic analysis of product pricing, and provided a rationale for many observed pricing policies. We also have identified key features in the business environment (such as the nature of the customer base and the type of information, i.e., held by managers) that can affect pricing decisions.
Given our intent, we have kept the analysis relatively simple. The actual im- plementation of a pricing strategy is complicated by a number of important fac- tors: First, the pricing policies presented in this chapter are not mutually exclu- sive. Many companies can and do use a combination of pricing policies (consider Beyond.com). Second, our analysis has focused primarily on pricing a single product, but most firms sell a variety of products. In many cases, it is important to consider the interactions of demands and costs of multiple products in developing a pricing strategy. Third, optimal pricing policies can change across time. Fourth, firms have to give more detailed consideration to the legal and strategic issues in formulating pricing strategies. Thus, to manage product pricing effectively, it is important to supplement the basic material presented in this chapter with industry experience and additional training in the economics of pricing.22
22The high salaries paid to successful pricing managers highlight the complexity of pricing decisions in some
industries. For instance, senior pricing managers are among the highest-paid professionals in major airline
companies. 23This case is based on a number of articles and SEC filings in the public domain. Among the most important
of these sources are J. Leeds (2005), “Apple, Digital Music’s Angel, Earns Record Industry’s Scorn,” New York Times (nytimes.com, August 27); and J. Leeds (2008), “Free Song Promotion Is Expected from Amazon,” nytimes.com (January 14).
ANALYZING MANAGERIAL DECISIONS: iTunes Music Pricing23
Consumers have been able to purchase digital
music and audiobooks over the Internet through
Apple Computer’s iTunes Music Store (Music
Store) since April 2003. The Music Store is inte-
grated with Apple’s iTunes Software, which allows
users to manage their digital music libraries and to
interface with their iPods, iPhones, iPads, and other
products.
Apple’s stock price increased from $1 per share
in April 2003 to over $95 per share in July 2014
(adjusted for stock splits). This 95-fold price in-
crease compares to Microsoft’s stock, which in-
creased from about $18 per share to $42 per share
over the same period. Apple’s strong performance
was fueled in part by the growth in its digital music
business. In August 2005, Apple’s market shares for
downloaded music and MP3 players in the United
States were approximately 75 percent and 80 per-
cent respectively. In 2013, Apple’s estimated mar-
ket share for downloaded music was 63 percent.
Chapter 7 Pricing with Market Power 249
Amazon, which introduced its online music store in
2008, was second with a market share of 22 per-
cent.
From the inception of the Music Store until
2009, Apple priced all downloaded music at $.99
per song. About $.70 per song was paid to the
major record companies that had the rights to the
songs. The record companies were initially happy
with this arrangement since it provided a way to
collect at least some revenue from downloaded
music. Prior to the development of iTunes, many
consumers downloaded music through services
such as Napster, with no royalties paid to the
music companies or artists.
By August 2005, Music Store sales had become
“big business” and two of the four major record
companies expressed dissatisfaction with the
$.99 price. Sony BMG Music Entertainment and
Warner Music favored a more complex pricing
scheme that would price songs by popularity. A
popular new single, for example, might sell for
$1.49, while a “golden oldie” might sell for sub-
stantially less than $.99. Executives from these
two music companies argued that their revenue
stream could be enhanced by flexible pricing.
They complained that Apple had an incentive to
sell downloaded music at too low a price to
promote the sale of iPods. To quote one music
company executive, “Mr. Jobs has got two revenue
streams: one from our music and one from the sale
of his iPods. I’ve got one revenue stream that it
would require a medical professional to locate. It’s
not pretty.”
Not all of the major record companies shared
the same view. For example, as of August 2005, the
Universal Music Group (a unit of Vivendi
Universal—the industry’s biggest company)
supported Apple’s desire to maintain the price of
$.99 a track.
The difference in opinion among the four
record companies reflected varying views on
whether the rapidly expanding digital market was
stable enough to bear a mix of prices—
particularly a higher top-end price. Millions of
consumers were still trading music free on
unauthorized file-swapping networks and an
increase in price would increase the incentives to
engage in this practice. One music executive
noted, “I don’t think it’s time yet. We need to con-
vert a lot more people to the habit of buying music
online. I don’t think a way to convert more people
is to raise the price.”
In 2014, Apple priced most downloaded music
at $1.29 per song. Adjusted for inflation, the 2014
price is very close to the 2003 price of 99 cents per
song. Apple, however, sold a limited number of
songs at 69 cents and 99 cents in 2014.
Over the years, Apple has had substantial
power in negotiating with the record companies.
No music company has tried to force Apple to
change its pricing policies by withholding its
music. Analysts, however, forecasted that Apple’s
leverage over the music companies could fall in
the future due to increased competition, for exam-
ple, from Amazon.com and major wireless compa-
nies who were likely to begin offering downloaded
music services to cell phone customers.
1. Provide an argument for why a more variable
pricing policy might increase the sales revenue
from Apple’s Music Store (compared to the flat
pricing policy).
2. Why do you think Apple moved from one to
three price points in 2009? What types of songs
do you think Apple tends to sell at the lower
prices?
3. Discuss other potential pricing policies that
might increase the revenue from Music Store
sales.
4. What are the risks and potential costs of imple-
menting more sophisticated pricing schemes
for the downloaded music?
5. Is Apple’s pricing objective to maximize the
revenue it receives from the sales of down-
loaded music? Is this the objective of the major
record companies? Explain. (Hint: review the revenue/product data from Apple’s 10-K—
available online at www.sec.gov/cgi-bin/srch-
edgar.)
6. Do you think that Apple’s ability to control the
pricing of downloaded music is likely to
change in the future? Explain.
250 Part 2 Managerial Economics
Summary A firm has market power when it faces a downward-sloping demand curve. Firms with market power can raise price without losing all customers to competitors. The ultimate objective is to choose a pricing policy that maximizes the value of the firm.
Consumer surplus is defined as the difference between what the consumer is willing to pay for a product and what the consumer actually pays when buying it. Managers, in maximizing profits, try to devise a pricing policy that captures as much of the gains from trade as possible. Thus, they try to capture potential consumer surplus as company profit.
In the benchmark case, the firm chooses a single per-unit price for all customers. Profits are maximized at the price and output level where marginal revenue equals marginal cost. Fixed and sunk costs are irrelevant; only incremental costs matter in the pricing decision. The optimal price markup over marginal cost depends on the elasticity of demand at the optimal price/quantity combination. The optimal markup decreases as demand becomes more elastic: It is optimal to charge high prices when customers are not very price-sensitive.
Economic theory suggests that managers should price so that marginal revenue equals marginal cost. One practical problem in applying this principle is that man- agers often do not have precise information about their demand curves and thus their marginal revenue. The linear approximation technique can be used when the demand curve is roughly linear and the manager has basic information about current price- quantity, price sensitivity, and marginal cost. Markup pricing is a technique that man- agers can use when they have limited information and reason to believe that price elasticity varies little across the demand curve. One of the most common pricing methods used by firms is cost-plus pricing. Managers using this technique calculate average total cost and mark up the price to yield a desired rate of return. Cost-plus pricing appears inconsistent with profit maximization since it includes fixed and sunk costs and does not consider consumer demand explicitly. Managers, however, can consider consumer demand implicitly by choosing appropriate target returns (lower target returns are chosen when demand is more elastic). The widespread use of this pricing policy suggests that it can be a useful rule of thumb in some settings.
The benchmark policy charges the same price to all customers independent of the quantity purchased. Sometimes a firm can do better with more complicated pricing policies. With block pricing a high price is charged for the first block and declining prices for subsequent blocks. Block pricing either can be used to extract additional profits from a set of customers with similar demands or can be used to price- discriminate. With a two-part tariff, the customer pays an up-front fee for the right to buy the product and then pays additional fees for each unit of the product consumed. Two-part tariffs tend to work best when customer demand is relatively homogeneous.
Price discrimination occurs whenever a firm charges differential prices across cus- tomers based on their willingness to pay for a given quantity of the good (not based on differences in production and distribution costs). With price discrimination, the markup or profit margin realized varies across customers. Two conditions are necessary for prof- itable price discrimination. First, different demand must exist in various submarkets for the product (customers must be heterogeneous). Second, the firm must be able to iden- tify submarkets and restrict transfers among consumers across different submarkets.
Personalized pricing extracts the maximum amount each customer is willing to pay for the product. Each consumer is charged a price that makes him or her indif- ferent between purchasing and not purchasing the product. Group pricing results when a firm separates its customers into several groups and sets a different price for each group. A firm that can segment its market maximizes profits by setting marginal revenue equal to marginal cost in each market segment (higher prices are charged to
Chapter 7 Pricing with Market Power 251
the less price-sensitive groups). Both personalized and group pricing require rela- tively good information about individual customer demands.
Even if the manager does not have detailed information about individual demands, price discrimination still is possible with sufficient information about the distribution of individual demands. With menu pricing all potential customers are given the same menu of options. The classic example involves block pricing, where the price per unit depends on the quantity purchased. Customers use their private information to select the best option for them. By carefully constructing the menu of options, the firm makes more profits than if it simply offered the product at one price to all potential customers.
Coupons and rebates offer price discounts to customers. Price discrimination is one reason why firms use coupons and rebates to make price discounts rather than simply lowering the price. Price-sensitive customers are more likely to use coupons and rebates—and thus are charged lower effective prices—than customers who are less price-sensitive. Similar to menu pricing, customers self-select, depending on private information about their personal characteristics. Coupon and rebate pro- grams are expensive to administer. These costs have to be compared to the benefits in deciding whether to adopt such a program.
Firms frequently bundle products for sale. One reason for bundling products is to extract additional profits from a customer base with heterogeneous product de- mands. Bundling can be more profitable than selling the products separately when the relative values that the customers place on the individual products vary.
This chapter focuses on a single-period pricing problem, in which managers face a fixed demand curve and cost structure. The prices of competing products are held constant. In some situations, concerns about future demand and costs, as well as the reactions of competitors, can motivate managers to choose pricing policies that would not be appropriate in the simple single-period analysis. Chapter 9 addresses is- sues of strategic interaction in greater detail.
T. Nagel 1994, The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making, 2nd edition (Prentice Hall: Englewood Cliffs).
C. Shapiro and H.Varian (1999), Information Rules: A Strategic Guide to the Network Economy (Harvard Business School Press: Boston).
7–1. ABC Software Solutions allows customers to access its software application remotely. Let P be the price charged to the customer each time the customer accesses the software. Cus- tomers are homogenous in their demands. The demand curve for each customer is P � 20 � 0.1Q, and ABC’s total cost for each customer is TC � 10 � 2Q. a. If ABC charges a single price per access (and no up-front fee), what are the optimal P
and Q per customer? Compute the profits per customer for ABC for this scenario. b. Suppose ABC charges a menu of two prices where each customer is charged one price
per access for up to 90 uses and a lower price per access for additional uses. For sim-
plicity, assume that ABC continues to charge the price determined in part a for the
first 90 units. What is the optimal price to charge for additional units? Compute the
profits per customer for this scenario.
c. If ABC decides to levy a two-part tariff, what are the optimal up-front fee, P, and Q per customer? What is the profit per customer for this scenario?
7–2. Consider a firm with MC � AC � 1 trading with two buyers, whose demand functions are Q1 � 5 � 2P1 and Q 2 � 7 � 3P2. The firm can distinguish the buyers and is able to price discriminate. Suppose the firm charges each buyer a single price per unit for the product.
What is the optimal price-discrimination strategy? Calculate the firm’s profits.
Self-Evaluation Problems
Suggested Readings
252 Part 2 Managerial Economics
7–3. The Key Club is a bar that has two types of potential customers: Legal and underage drinkers. It is illegal to allow entry to underage drinkers, but there is no way to perfectly
identify underage drinkers (fake IDs, etc.). Assume that Key Club’s marginal cost is $3 per
drink. The drink demand for a representative customer in each of the two groups is given by
PL � 5 � Q L (legal drinkers)
PU � 3.5 � Q U (underage drinkers)
Design a pricing policy that will extract all of the profit from the legal drinkers without appealing to underage drinkers at all.
7–4. Company XYZ supplies two products, DVD discs and DVD storage cases, to two different segments of customers (1 and 2). The following table summarizes the value that the typical
customer in each segment assigns to the products offered by XYZ:
Customer Type Discs Cases
1 $6 $8 2 $7 $5
Assume that there are 10 customers of each type, that XYZ has no fixed costs, and that the
marginal costs of producing discs and cases are both constant at zero.
a. What is the pricing strategy for XYZ if it prices the products individually? What is the corresponding profit?
b. If XYZ decides to offer discs and cases in a bundle, what price should it charge for the bundle? Is bundling a better strategy in this case? Why? Explain.
Solutions to Self-Evaluation Problems 7–1. Homogenous Consumer Demands
a. Profit maximization occurs when MR � MC: 20 � .2Q � 2. Thus, Q* � 90 and P* � $11. Profits/customer (TR � TC) � $800.
b. The problem assumes that ABC will continue to charge $11 for the first 90 uses. This leaves a residual demand curve of P � 11 � .1Q (at a price of $11, no additional units are purchased; additional units are purchased as the firm lowers it price below $11 for
the additional uses). Setting MR � MC for this curve: 11 � .2Q � 2 yields and optimal price and quantity of Q** � 45 and P** � $6.50. Each customer ends up purchasing 135 units, (the first 90 at the $11 price and 45 additional units at the $6.50 price). Total
profits/customer for the two-price scheme: (90 � $11) � (45 � 6.50) � (10 � 270) � $1,002.50. Graphically the solution looks as follows:
(Note: ABC could do slightly better if it solved for the two prices simultaneously. The problem held the first price constant to simplify the analysis.)
P
$11
$6.50
90 135 200 Q
Residual demand curve
$20
Chapter 7 Pricing with Market Power 253
c. Under the profit-maximizing two-part tariff, ABC would charge MC � $2 for each access to its software. Each customer would access the software 180 times at this
price (from the demand curve). Charging marginal cost maximizes the gains from
trade (a customer accesses the software whenever he values it more than the cost to
the company). ABC should charge an up-front fee that extracts all of these gains
from trade as profit. Graphically the up-front fee is represented by the area of
Triangle A in the following diagram. The area of a triangle is .5(base � height). Therefore the optimal up-front fee is .5(18 � 180) � $1,620. Total revenue from both the price/unit and the fee is $1,980. Total costs are [$10 � (2 � 180)] � $370. Thus the profit/customer from this scheme is $1,610. ABC obtains the maximum
possible profits using the two-part tariff. It does worse with the quantity discount
scheme and even worse with the single price scheme.
7–2. Group Pricing
Begin by solving the demand functions to obtain the two demand curves:
P 1 � 2.5 � .5Q1
P 2 � (7�3) � 1�3 Q2
Set marginal revenue equal to marginal cost in both segments (the profit-maximizing
conditions):
2.5 � Q1 � 1
7�3 � 2�3 Q2 � 1
Next, solve for the equations to obtain the optimal quantities. Use these quantities and the
demand curves to find the optimal prices: Q1* � 1.5 and P1* � $1.75, and Q2* � 2 and P2* � $1.67. Profits are equal to the sum of total revenue—total costs for the two segments: ($1.125 � $1.34) � $2.46.
7–3. Using Information about Distribution of Demands
A two-part tariff can be used to extract all the profit from the legal drinkers. Charge
them $3.00 per drink (MC) and have a cover charge equal to their consumer surplus
(1�2 � (.5 � .3) � 2) � $2.00. The underage drinkers will not pay the cover charge to enter since their consumer surplus given a price of $3.00 per drink is less than
the cover charge of $2.00. Their consumer surplus (before the cover charge) is
(1�2 � ($3.50 � 3.00) � .5) � $.125. This pricing scheme motivates potential customers, who know their own types, to make choices that are consistent with the
Club’s objective of maximizing profits from legal drinkers without serving underage
drinkers.
P
180 200 Q
$2
$2
A
Optimal up-front fee is equal to the area of Triangle A: .5(18 � 180) = $1,620.
Optimal price for each access of the software
254 Part 2 Managerial Economics
7–4. Product Bundling a. Because marginal cost is equal to zero, maximizing revenue is the same as maximizing
profit. By charging the low reservation price for each product (discs and cases), XYZ
will sell both products to both types of customers. This is the profit-maximizing strategy
for the separate pricing case in this example. Therefore, XYZ should charge:
$6 for discs
$5 for cases
The corresponding profit is 6 � 20 � 5 � 20 � $220. Profit is lower if either or both products are priced higher and sold to only one customer type. (Note: If the number of customers of each type changed, other strategies might be optimal. For example, if
there were 100 Type 1 customers and one Type 2 customer, XYZ would be better off to
price cases at $8 and sell them only to the Type 1 customers. The optimal solution could
also be different with different assumptions about the marginal costs of producing the
two products.)
b. A Type 1 customer has a reservation price of $14 (8 � 6) for the bundle, whereas a Type 2 customer has a reservation price of $12 (7 � 5). Given that there are an equal number of customers of each type, profits are maximized by charging $12 for the bun-
dle. This is the highest price that ensures XYZ can sell the bundle to both types of cus-
tomers. The corresponding profit is $12 � 20 � $240. Bundling results in higher profits than the individual product pricing strategy because
the reservation prices for the two customer types are negatively correlated. Type 1 cus-
tomers value cases more than Type 2 customers (8�5 � 1), whereas Type 2 customers value discs more than Type 1 customers (7�6 � 1). This negative correlation implies that the minimum reservation price for the bundle (� $12 for the Type 2 customers) is greater than the sum of the minimum reservation prices for the individual products ($11 � $5 � $6). Thus more revenue per customer is collected by selling the products in a bundle for
$12, rather than pricing them separately at $5 and $6.
7–1. Macrosoft is a new producer of word processing software. Recently, it announced that it is giving away its product to the first 100,000 customers. Using the concepts from this chap-
ter, explain why this might be an optimal policy.
7–2. The local space museum has hired you to assist them in setting admission prices. The mu- seum’s managers recognize that there are two distinct demand curves for admission. One
demand curve applies to people ages 12 to 64, whereas the other is for children and senior
citizens. The two demand curves are
PA � 9.6 � 0.08QA PCS � 4 � 0.05QCS
Review Questions
P
2 Q
$5
$3
CS = $2
Legal drinkers
P
.5 Q
$3.50
$3
Underage drinkers
CS = $.125
Chapter 7 Pricing with Market Power 255
where PA is the adult price, PCS is the child/senior citizen price, QA is the adult quantity, and QCS is the child/senior citizen quantity. Crowding is not a problem at the museum, and so managers consider marginal cost to be zero.
a. What price should they charge to each group to maximize profits? b. How many adults will visit the museum? How many children and senior citizens? c. What are the museum’s profits?
7–3. Textbook publishers have traditionally produced both United States and international edi- tions of most leading textbooks. The United States version typically sells at a higher price
than the international edition. (a) Discuss why publishers use this pricing plan. (b) Discuss how the Internet might affect the ability of companies to implement this type of policy.
7–4. Suppose in Table 7.2 (Product Bundling) that the professional user values Microsoft Trip Planner at $30 rather than $20. Keep all other valuations the same. Are there still obvious advantages from bundling the two products? Explain.
7–5. Explain why perfect personalized pricing is typically more profitable than menu pricing. Why then do companies use menu pricing?
7–6. In the example in this chapter, the linear approximation method produced the profit- maximizing price, whereas the markup pricing rule did not. Does this imply that the linear
rule is always better than the markup rule? Explain.
7–7. Why do companies grant discounts to senior citizens and students?
7–8. You own a theater with 200 seats. The demand for seats is Q � 300 � 100P. You are charg- ing $1.25 per ticket and selling tickets to 175 people. Your costs are fixed and do not depend
on the number of people attending. Should you cut your price to fill the theater? Explain.
What other pricing policies might you use to increase your profits?
7–9. The Snow City Ski Resort caters to both out-of-town skiers and local skiers. The demand for ski tickets for each market segment is independent of the other market segments. The
marginal cost of servicing a skier of either type is $10. Suppose the demand curves for the
two market segments are
Out of town: Q 0 � 600 � 10P
Local: Q 1 � 600 � 20P
a. If the resort charges one price to all skiers, what is the profit-maximizing price? Calcu- late how many lift tickets will be sold to each group. What is the total profit?
b. Which market segment has the highest price elasticity at this outcome? c. If the company sells tickets at different prices to the two market segments, what is the
optimal price and quantity for each segment? What are the total profits for the resort?
d. What techniques might the resort use to implement such a pricing policy? What must the resort guard against, if the pricing policy is to work effectively?
7–10. All consumers have identical demand for a product. Each person’s demand curve is P � 30 � 2Q. The marginal cost of production is $2. Devise a two-part tariff that will exhaust all consumer surplus.
7–11. Xerox sells both copiers and a toner for their copiers. While customers are not required to buy Xerox toner, most do because specified machines use toner only for that machine. The
Xerox toner and machines are closely designed and non-Xerox toner in Xerox machines
produces inferior copies. Evaluate the statement: “Xerox makes 75 percent of its profits
selling toner and 25 percent of its profits selling machines.”
7–12. Some tennis clubs charge an up-front fee to join and a per-hour charge for court time. Others do not charge a membership fee but charge a higher per-hour fee for court time.
Consider clubs in two different locations. One is located in a suburban area where the
residents tend to be of similar age, income, and occupation. The other is in the city with a
more diverse population. Which of the locations is more likely to charge a membership
fee? Explain.
7–13. Consider three firms: a shoe store at the mall, an automobile dealership, and a house paint- ing firm.
a. Which firm would you expect to engage in the most price discrimination? Why? b. How has the Internet changed the pricing policies of these businesses?
7–14. Cellwave is a cellular phone company. Answer the following questions relating to its pricing policies:
a. When Cellwave started, it sold to a group of homogeneous retail customers. Each per- son’s monthly demand for cell phone minutes was given by P � $2 � 0.02Q , where P � the price per minute and Q � the quantity of minutes purchased each month. Cell- wave’s marginal cost is 10 cents per minute. Suppose that Cellwave charges a single per
minute price to all customers (independent of the number of minutes they use each
month). What is the profit-maximizing price. Depict this choice on a graph. On a per
customer basis, what are the company’s profit, consumer surplus, and the deadweight
loss?
b. Suppose that Cellwave chooses to charge a two-part tariff (with a monthly fixed charge and a per minute rate) rather than a single per minute price. What two-part tariff extracts
the entire consumer surplus? What are the company’s profits (on a per customer basis)?
How many minutes does each customer use per month? What is the deadweight loss?
c. After several years of operation, Cellwave developed a new group of business customers (in addition to its old customer base). The business customers had homogeneous
demands. Each of these customers’ monthly demand for cell phone minutes was given
by P � $2 � 0.004Q. Graph the two demand curves for the two customer groups on the same figure along with the marginal cost. Suppose that Cellwave wants to menu price
by offering two plans with different monthly fixed charges. Each plan would allow free
calls up to some maximum limit of minutes per month. No calls are allowed beyond
these maximums. Assume that Cellwave designs a plan that extracts all consumer
surplus from the retail customers. Shade the area of the graph that shows how much
consumer surplus must be given to each business customer to make the plan work.
Explain why.
7–15. The Hewl-Pact Company produces a popular printer than prints over 100 pages per minute. It recently announced that it was introducing a lower priced model of the printer that can
print 30 pages per minute. While not revealed to the public, it turns out that it costs the
company more to produce the lower priced product. The two models are identical except for
a $20 internal part for the low-priced model that slows the printer from 100 to 30 pages per
minute. Provide an economic explanation for why the company decided to produce a new
lower priced, but more costly, model of the printer.
256 Part 2 Managerial Economics
chapter
8 C H A P T E R O U T L I N E
Strategy Value Creation
Production and Producer Transaction Costs Consumer Transaction Costs Other Ways to Increase Demand New Products and Services Cooperating to Increase Value Converting Organizational Knowledge into Value Opportunities to Create Value
Capturing Value Market Power Superior Factors of Production A Partial Explanation for Walmart’s Success All Good Things Must End
Economics of Diversification Benefits of Diversification Costs of Diversification Management Implications
Strategy Formulation Understanding Resources and Capabilities Understanding the Environment Combining Environmental and Internal Analyses Strategy and Organizational Architecture Can All Firms Capture Value?
Summary
O ver the past five decades, Walmart Stores rose from “humble be- ginnings” as a small discount retailer in Arkansas to become the world’s largest retailer with more than $476 billion dollars in sales in 2014.1 Its discount-variety stores, Sam’s Clubs,
supercenters (combined discount retail and bulk grocery stores) and smaller “neighborhood” and express stores are located throughout the United States, as well as in many other countries such as Mexico, Canada, Puerto Rico, Germany, Brazil, Argentina, China, Korea, and Indonesia. In 2014, Walmart operated over 11,000 retail units under 71 banners in 27 countries with e-commerce websites in 10 countries. It employed 2.2 million people around the world (1.3 million in the United States).
Since Sam Walton opened his first store in 1962, the overall financial per- formance of the company has been nothing less than phenomenal. To illus- trate, suppose you had purchased $1,000 of the stock at the initial offering in 1970 and held it through 2008. This investment would have been worth more than $5 million (i.e., a 20 percent compound annual growth rate); in addition, you would have received cash dividends paid by the company over the period. This performance made Walmart one of the hottest stocks in the market.
Economics of Strategy: Creating and Capturing Value
L E A R N I N G O B J E C T I V E S
1. Explain the general ways by which managers within an industry might increase value.
2. Discuss how competitive forces make it difficult for individual firms to capture value over the long term.
3. Explain why producer surplus is often captured as “rents” by superior assets. 4. List the conditions that must exist for a firm to make economic profits over the
long run.
5. Summarize the economic costs and benefits of diversification (multiple businesses within the same firm).
6. Describe a general framework that can be used for strategic planning. 7. Show why it is impossible for some firms to capture value and why it is
unlikely that any firm can capture value in perpetuity.
1Details for this example are from Fortune 500 (2014), http://fortune.com/fortune500; Walmart—
Our Story (2014), http://corporate.walmart.com/our-story; S. Foley (1994), “Wal-Mart Stores,
Inc.,” Harvard Business School Case 9-794-024; the financial press; company reports; and
C. Loomis (2000), “Sam Would Be Proud,” Fortune (April 17), 131–144.
258 Part 2 Managerial Economics
While Walmart’s performance has been spectacular, it has not been flawless. Following a large price drop in the second quarter of 1993 (over 20 percent during a period when the overall market was essentially flat), Walmart’s stock price continued to decline modestly until 1997, even though the overall stock market was rising. In addition, sales growth at Walmart, which for a long period had outpaced the retail industry, fell to unremarkable levels.
In an attempt to increase performance during the 1990s, Walmart took a variety of actions; it opened new stores internationally, opened new supercenters, and logged on to the world of electronic commerce. In 1998, Walmart entered the traditional grocery store business in Arkansas where it opened three “experimental” 40,000-square-foot grocery stores (about the same size as traditional supermarkets). During the period from 1997 to 2005, Walmart stock again performed well relative to the general stock market and retail industry. Between 2006 and 2014, Walmart continued to perform somewhat better than the general stock market, but did substantially worse than Costco Wholesale Corporation. It, however, performed much better over this period than its rival, the Target Corporation. In July 2014, Walmart's new CEO announced a strategic shift from focusing on large supercenters to smaller stores and online sales.
All managers would like to outperform the general market as well as their specific industry over a sustained period. Examples like that of Walmart suggest that such performance is possible but raise at least five important questions:
• What accounts for the success of these firms?
• Should all properly managed firms expect sustained superior performance?
• What actions can managers take to generate superior performance?
• Can managers enhance financial returns through diversification (as Walmart was attempting to do by opening grocery stores)?
• Do all high-performing firms ultimately “fall back with the rest of the pack” as Walmart did in the mid-1990s?
This chapter applies the basic economic concepts developed in this book to ad- dress these and related questions.
Strategy Strategy refers to the general policies that managers adopt to generate profits. For ex- ample, in what industries does the firm operate? What products and services does it offer and to which customers? In what basic ways does it compete or cooperate with other firms within its business environment? Rather than focusing on operational de- tail, a firm’s strategy addresses broad, long-term issues facing the firm.2 Typically, strategies do not remain constant but evolve through time. For example, Walmart’s strategy in 2014 focuses on discount retailing and the related grocery industry, as well as online sales. It owns and operates five basic types of stores in the United States: discount-variety stores, Sam’s Clubs, supercenters, neighborhood markets, and express stores. It offers a wide product assortment, “every-day low prices” (supported by a low-cost structure), limited advertising, and friendly, well-informed
2In the strategy literature, these questions are frequently divided: Corporate strategy refers to the choice of
industries, whereas business strategy refers to the choice of how to compete within the chosen industries
(e.g., whether to focus on cost or quality, or on some combination of the two).
Chapter 8 Economics of Strategy: Creating and Capturing Value 259
“sales associates.” Originally, its strategy focused on placing stores in the rural Southeast. Walmart now operates stores throughout the world. Ultimately, along with the organizational architecture of the firm, strategy is a key determinant of the success or failure of the enterprise.
The ultimate objective of strategic decision making is to realize sustained profits.3
To achieve this objective, managers must devise ways both to create and to capture value. Earlier chapters focused on how value might be created and captured through input, output, and pricing policies. Those chapters also analyzed how competition constrains the ability of managers to capture value. But they (like most discussions in the traditional managerial economics literature) focused on a single product, tak- ing the industry and product characteristics as given.
This chapter takes a broader look at how managers create and capture value. The next section presents an analysis of value creation within a given industry. Subse- quent sections examine capturing value and the choice of industries. The final sec- tion offers a general framework for implementing the concepts in this chapter.
Firms often compete against a few identifiable rivals. For example, Boeing com- petes largely with Airbus in the production of commercial jet airplanes. It is particu- larly important for managers in such firms to consider likely responses of rivals when making strategic decisions about pricing, new investment, advertising, and so on. For example, it would be foolish if Boeing failed to consider likely responses by Airbus in setting the prices of its wide-body jets. In this chapter, we concentrate on the broader issues of how firms create and capture value; thus we abstract from how reactions by rivals might be incorporated explicitly in the analysis. In the next chapter we use game theory to provide an explicit analysis of reactions by rivals in the strategic decision-making process.
Value Creation Figure 8.1 displays supply and demand curves for an industry. It differs from our previous supply and demand figures in one important respect: It explicitly displays both consumer-borne and producer-borne transaction costs. Consumer transaction costs include such things as the costs of searching for the product, learning product characteristics and quality, negotiating terms of sale with a supplier, and enforcing agreements. If these costs were lower, demanders would be willing to pay more for the product. For example, automatic teller machines increase the demand for banking services by reducing the amount of time customers spend in line and by providing basic banking services around the clock. The dotted demand curve indicates poten- tial demand—what demand would be if consumer-borne transaction costs could be eliminated. The solid demand curve displays the effective demand given a per-unit consumer transaction cost of a. Similarly, producers bear costs in transacting with consumers and suppliers (e.g., negotiating terms with customers and paying attorneys to draft a supply agreement). The dotted supply curve indicates potential supply— the willingness of producers to supply the product if producer transaction costs were
3If stock market participants anticipate that a company is going to earn sustained abnormal profits, its stock
price will be bid up so that in equilibrium investors will expect to earn only a normal rate of return by buying
the stock. The fact that Walmart has generated both high profits and high stock returns over a long time period
suggests that the company has repeatedly surprised the stock market with its earnings performance. In this
book, we concentrate on the underlying profits of the company, not the stock market valuation of these
profits. Stock market valuation is covered in finance classes and textbooks.
260 Part 2 Managerial Economics
eliminated. The solid line shows the effective supply curve given a per-unit transac- tion cost of b.4
The area under the dotted demand curve (demand before transaction costs) and above the dotted supply curve (supply before transaction costs) up to Q * is divided into four areas. First, there are the two parallelograms representing consumer and producer transaction costs. Next, there are the two triangles representing consumer and producer surpluses. Total value created by the industry is the sum of producer surplus and consumer surplus.
An important first step in making profits is discovering ways to create value. The second step, discussed below, devises ways to capture this value. Figure 8.1 suggests at least four general ways that managers within the industry might increase value.
• They can take actions to lower production costs or producer transaction costs, thus shifting the effective supply curve to the right.
• Managers can implement policies to reduce consumer transaction costs, thus shifting the effective demand curve to the right.
• They can take actions other than reducing consumer transaction costs to increase demand, shifting both the potential and effective demand curves to the right.
• Managers can devise new products or services—in essence creating a new figure.
We discuss each of these strategies in turn.5
Consumer surplus
Producer surplus
Consumer-borne transaction costs
Pro duc
er-b orn
e tr ans
act ion
co sts
Effective supply given transaction costs
Potential supply if no transaction costs
Potential demand if no transaction costs
Effective demand after transaction costs
$
Q *
Quantity
a
b
P *
Q
P ri ce
( in
d o lla
rs )
Figure 8.1 Ways to Create Value
This figure displays the supply and demand curves for an industry. It differs from previous diagrams by including producer and consumer transaction costs. [Per-unit consumer-borne (producer-borne) transaction cost is a(b).] Consumers would demand more and producers would supply more if these costs were lower. Value consists of the sum of consumer and producer surplus. Managers can increase value by reducing transaction or production costs or by increasing the demand for the product—for example, by increasing the perceived quality of the product.
4For expositional convenience, we assume that supply costs are separable into production and transaction
costs. Admittedly, there are cases where they are joint or where the allocation is arbitrary. 5We depict demand and supply at the industry level because it facilitates our subsequent discussion on
capturing value (which involves competition within the industry). The same four value-creating factors are
important if we frame the problem using a firm’s demand and costs.
Chapter 8 Economics of Strategy: Creating and Capturing Value 261
Production and Producer Transaction Costs
Chapter 5 discussed how managers should choose inputs to minimize production costs. Over time, managers can discover new technological opportunities to reduce these costs and increase value. They also can devise ways to lower the costs of trans- acting with customers and suppliers. For example, when personal computers first were developed, they were relatively expensive to produce. Over time, companies learned to reduce these production costs. As a result, the quantity of personal com- puters sold in the market has increased substantially—as has the total value (con- sumer plus producer surplus) created within this industry. Computer manufacturers also have devised ways to reduce their costs of transacting with suppliers and cus- tomers. For instance, large computer manufacturers have developed electronic con- nections with major software producers to lower the cost of ordering software pro- grams. They also have developed computer links that reduce their costs of transacting with customers.
Walmart has shifted its effective supply curve to the right by developing new low- cost methods for producing and distributing retail services and products. For exam- ple, its extremely efficient hub-and-spoke distribution system has lowered the costs of stocking its stores. Walmart has reduced transaction costs through direct computer links with major suppliers, such as Procter and Gamble. These links have cut the costs of restocking products and essentially have eliminated writing paper checks to these vendors—they are paid through an electronic payment system.
Consumer Transaction Costs
Reducing consumer transaction costs also can increase value. For example, early Walmarts were established in small rural towns. One way that these stores added value was through reducing travel time for local residents, who previously had to
M A N A G E R I A L A P P L I C AT I O N S
Creating Value: Reducing Consumer Waiting Time Many firms undervalue their customer’s waiting time. In 2000 the Oregon Public Utilities Commission ordered Qwest
Communications to pay consumers $270 million to compensate them for installation delays. Cable companies require a
four-hour window for appointments. Some doctors keep four busy patients waiting for every one that the doctor is
seeing. If U.S. citizens value their time at $20 per hour, taxpayers spend $26 billion a year filing tax returns. Some
companies recognize the value of their customers’ time and build successful corporate strategies around reducing
waiting time. Suppose a customer’s after tax earnings are $100,000 and she works 2,000 hours; then her time is worth
$50 per hour. If she decides to buy the latest $20 John Grisham novel at a bookstore, she might spend an hour driving
to and from the store, parking, locating the book, and purchasing it. The total cost to purchase the book is $70.
Compare that to spending six minutes buying the book online for $20 plus $4.50 shipping. The total cost of the online
purchase is $29.50 (including the $5 for her time) for a saving of $40.50. In fact, most e-tailers’ business strategy is to
economize on customer time. The following companies have strategies aimed at conserving customer time. Wendy’s
serves up Big Bacon Classic within two-and-a-half minutes. Enterprise offers at-home pickup and return of rental cars.
Virgin Atlantic Airlines picks up and checks in upper-class passengers from their chauffeured cars. J.C. Penney offers
three-day delivery or in-store pickup of online orders.
Source: K. Barron (2000), “Hurry Up and Wait,” Forbes (October 16), 158–164.
262 Part 2 Managerial Economics
drive to urban centers to do a larger part of their shopping. Walmart also reduces consumer-borne transactions costs by the layout of their stores. For example, Walmart captures “market-basket data” from customer receipts at all its stores. By analyzing this data, Walmart can tell which products are likely to be purchased to- gether. Walmart uses this knowledge to reduce customers’ costs in navigating their stores by placing commonly purchased bundles of products together. Examples of such pairings include bananas with cereal, snack cakes with coffee, bug spray with hunting gear, tissues with cold medicine, measuring spoons with baking supplies, and flashlights with Halloween costumes.6
The entire industry that involves marketing over the Internet is another example of reducing consumers’ transaction costs. For instance, when prospective customers use search engines to explore the Internet, they often are presented with a list of re- lated books, which can be ordered electronically at a discount through companies such as Amazon.com. This service reduces consumer transaction/search costs by identifying books of potential interest and making it easier to place an order.
Other Ways to Increase Demand
The demand curve holds variables other than the price of the product constant. We already have discussed how managers can increase demand by reducing consumer transaction costs. They also can increase the effective demand for their products— and thus total value created through transactions—by affecting variables such as expected product quality, prices of complements, or prices of substitutes.
6E. Nelson (1998), “Why Wal-Mart Sings, ‘Yes, We Have Bananas!’” The Wall Street Journal (October 6), B1.
M A N A G E R I A L A P P L I C AT I O N S
The U.S. Government’s Global Entry Program Reduces Consumer Transaction Costs Since the terrorist attack on the World Trade Center in 2001, international fliers have been subjected to increased
security checks when entering the United States. The associated increase in waiting times imposes transaction costs on
international fliers and potentially decreases the demand for international travel.
The U.S. government’s Global Entry program is designed to reduce the time it takes for “low-risk” fliers to enter
the country. U.S. citizens (and certain others) can apply for a Global Entry pass online. After receiving preliminary
approval, the applicant must complete an in-person interview with a U.S. customs agent at selected locations, during
which the person is also photographed and fingerprinted.
Pass holders entering the United States from international flights head directly to a passport kiosk (at major
airports) where they answer a few questions on a computer monitor. This process avoids having to wait in line for
standard passport control agents. There are also special lines for pass holders to reduce the time they spend clearing
customs.
A study released in July 2014, found that the use of Global Entry kiosks reduced average wait times by 33 percent
at New York’s JFK airport and more than 15 percent at New Jersey’s Newark Liberty airport.
U.S. Customs and Border Protection spokeswoman Jennifer Evanitsky says the agency recognizes the importance
of international travel to the nation’s economy. The kiosks allow the agency’s officers “to facilitate legitimate
international travelers as quickly as possible while maintaining the highest standards of security,” she says. This
example, illustrates how technology often reduces consumer transaction costs.
Source: G. Stoller (2014), “Passport Kiosks Reduce Fliers Customers Wait Time,” USA Today (July 16).
Chapter 8 Economics of Strategy: Creating and Capturing Value 263
Product Quality Actions that enhance perceived quality increase demand; total value also is raised unless these actions entail larger increases in production costs. For instance, the in- novation of titanium golf clubs increased the demand for golf equipment, while the invention of parabolic skis increased the demand for skis and skiing. Another impor- tant dimension of product quality is delivery time. Most consumers prefer to receive products sooner rather than later. Amazon, in particular, recognizes this and strives to deliver its products to consumers faster than its competitors (even exploring the use of drones). The resulting increases in demand have been greater than the associ- ated increases in production costs—thus, total value created within these industries has increased.
Price of Complements Managers sometimes can act to reduce the price of complements, thus increasing the demand for their products. To illustrate, consider CompuInc, which produces per- sonal computers, and PrintCo, which produces a complementary printer.7 For sim- plicity, suppose that customers purchase either both products or neither product (they are quite strong complements), the price of CompuInc’s personal computers is Pc, the price of PrintCo’s printers is Pp, and the demand for each product is
Q � 12 � (Pc � Pp) when Pc � Pp is 12 or less, 0, otherwise (8.1)
Q (measured in thousands) is the number of computer–printer combinations sold, and the marginal cost of producing both products is 0.
If the two companies do not cooperate in setting prices, each will seek to maxi- mize its individual profits, given its expectation of the other firm’s price. In this case, CompuInc will view its demand curve as
Pc � (12 � P �
p) � Q (8.2)
while the PrintCo demand curve is
Pp � (12 � P �
c) � Q (8.3)
where P �
p and P �
c represent the expectations about the other firm’s price. 8 Each firm’s
profit is maximized by setting MR � MC (0 in this example):
CompuInc (12 � P �
p) � 2Q � 0 (8.4)
PrintCo (12 � P �
c) � 2Q � 0 (8.5)
Giving Away Razors to Increase Demand for Blades King Gillette gave away free razors after he invented his famous double-edge disposable blade in 1885—United Cigar
Store gave razors to customers who bought boxes of Cuban cigars—banks bought razors for pennies and gave them
away as part of shave-and-save campaigns. These promotions were designed to get razors in the hands of consumers
who would then buy a stream of future blades for the razors. In 2005 Gillette was acquired by P&G for $57 billion.
Source: (1999), “No Charge,” Attaché (September), 14–16; and A. Coolidge (2005), “Gillette: P&G Not Our First Choice,” The Cincinnati Post (March 16).
H I S T O R I C A L A P P L I C AT I O N S
7See A. Brandenburger (1996), “Cheap Complements?” (mimeographed text, Harvard Business School). 8There is no reason to place a subscript on Q. By assumption it is the same for both firms.
264 Part 2 Managerial Economics
Substituting for Q from Equation (8.1) and rearranging the terms yield the following two reaction curves:
Pc � 6 � 0.5P �
p (8.6)
Pp � 6 � 0.5P �
c (8.7)
The equilibrium consists of prices P*p and P*c that simultaneously solve these two equations.9 Figure 8.2 displays the solution graphically. In equilibrium, both firms choose a price of $4; thus, a total of 4 units of each product is sold. The profit for each firm is $16,000; combined profits are $32,000.
Now consider what happens if the firms were to coordinate the prices, for exam- ple, through a joint venture. To maximize the combined profits, the companies jointly set marginal revenue equal to marginal cost:10
12 � 2Q � 0 (8.8)
They sell 6,000 units at a combined price of $6 (e.g., Pc � Pp � $3). In this case, they make a combined profit of $36,000. This combined profit by pricing the products jointly is higher than the profit they would receive if they do not cooperate in setting prices. When the firms price independently, they do not consider the negative effect
9Recall from Chapter 6 that a Nash equilibrium is where each firm is doing the best it can, given the actions
of its rivals. 10Note that the combined demand curve is (Pc � Pp) � 12 � Q ; MR � 12 � 2Q.
Pc
Pp
P * = 4 6 12
12
6
P * = 4
CompuInc’s reaction curve in choosing Pc
PrintCo’s reaction curve in choosing Pp
Price of personal computers ($)
P ri ce
o f P
ri n tC
o p
ri n te
rs (
$ )
c
p
Figure 8.2 Noncooperative Pricing for CompuInc and PrintCo
If the two companies price noncooperatively, each will try to maximize its individual profits given its expectation of the other firm’s price. The equilibrium consists of prices P*p and P*c, which simultaneously solves these maximization problems. This figure displays the solution graphically. The figure displays the reaction curves for each firm. A given firm’s reaction curve indicates its optimal price given the pricing decision of the other firm. In equilibrium (where the reaction curves cross), both firms choose a price of $4. A total of 4,000 units of each product is sold. The profits for each firm are $16,000. Combined profits are $32,000. (Note: If they cooperate and set each price at $3, combined profits will be $36,000.)
Chapter 8 Economics of Strategy: Creating and Capturing Value 265
that their higher prices have on the other’s profit. Pricing cooperatively, they take this interaction into account. Note that in this case, consumers also would be better off be- cause the prices of both products are lower and as a result, more product is purchased.
Prices of Substitutes Low-priced substitutes reduce the demand for a product. Sometimes managers can affect the price of substitutes. For example, movie theaters frequently prohibit pa- trons from bringing food into the theater. These restrictions on lower-priced substi- tutes increase the demand for snacks offered by the theater.
New Products and Services
To this point, our discussion has focused on creating value by increasing demand or reducing the costs of producing existing products. Inventing new products and services also creates value. For example, consider the consumer electronics industry. Many of today’s products that create significant value are relatively new developments: for instance, MP3 technology, digital cameras, and digital video displays (DVDs).11
Cooperating to Increase Value
Our example of computers and printers shows that firms sometimes can increase value through cooperating with each other, rather than competing. In this case, the companies were producers of complementary products. Opportunities to increase value through cooperation also can arise with customers, suppliers, and even competitors. For instance, cooperating with suppliers and customers in developing computer and information links can reduce supply costs and lead to the production of more valuable products—ones more tailor-made for the customer (recall the exam- ple of Dell Computers). One way competitors cooperate is in development projects to reduce joint costs. For example, major automobile manufacturers have partici- pated jointly in the research and development of batteries for electric cars. Longer- lived batteries are essential for these companies to market electric cars on a wide- scale basis. If each company acts independently, development costs are expected to be higher. As another example, offshore drilling is quite expensive. Prior to soliciting
11Obviously, the classification of whether a product development constitutes a product improvement or a new
product is somewhat arbitrary. For example, are Blu-ray players separate products or improvements over
previously existing DVD players? This classification problem is not central to our focus. The basic point is
that value often is created through the development/enhancement of products.
M A N A G E R I A L A P P L I C AT I O N S
Technology and Value During the later part of the 20th century there has been a massive change in information, communication, and
production technologies. This technological change has provided important opportunities for increasing value. For
example, the “business process reengineering” movement in the 1990s used computer and information technology to
lower costs (for instance, by streamlining systems used to process orders, shipments, payables, and receivables).
Flexible production technologies have allowed firms to custom-design certain products to fit specific customer
demands better. Computer and information technologies have been used to reduce the costs of transacting with
suppliers. Using technology to increase value is likely to remain a significant focus well into the 21st century.
266 Part 2 Managerial Economics
bids for offshore sites, the U.S. government allows the oil firms to conduct a survey of the area jointly; they share the data and divide the costs.
American antitrust laws generally make it illegal for rival firms to cooperate for the purpose of monopoly pricing. Nonetheless, many forms of cooperation are legal and increase the welfare of both producers and consumers (again consider our PC-printer example).
Converting Organizational Knowledge into Value
To create value, employees must convert their existing knowledge about production processes, transaction costs, customer demand, and so on, into ideas that can be im- plemented by the firm. In Chapter 3, we discussed the knowledge conversion process. In this section, we consider the strategic implications of this analysis. Recall that the resources within a firm can be divided into three general categories. First are its tangible assets, which include property, plant, and equipment. Second are its in- tangible assets, such as patents, trademarks, and brand-name recognition. These as- sets typically are not shown on the firm’s balance sheet but can be significant in cre- ating and capturing value—the firm’s methods of doing business, its formulas and recipes, are a particularly important type of intangible asset. Third and perhaps most important are its human resources.
Firms in Silicon Valley frequently refer to these three types of resources as hardware, software, and wetware. Hardware consists of physical assets. Software is broadly used to describe the firm’s “soft” assets, such as its formulas and recipes for creating value. Wetware refers to employee brainpower, that is, “wet computers.”
A firm owns and thus can capture value from its hardware and software, but it only “rents” its wetware. Wetware is the private property of individual employees, who can take it with them to another firm if they so choose. To create and capture value, managers must find ways to convert the knowledge contained in employee wetware—even knowledge the employees may not realize they have—into software.
The evolution of the McDonald’s Corporation provides a good example of how this process occurs. The first McDonald’s unit was established in 1956. The
M A N A G E R I A L A P P L I C AT I O N S
Research and Development Joint Ventures Firms can sometimes increase their values by cooperating with competing firms. One example is research and
development (R&D) joint ventures. R&D costs are particularly high in the pharmaceutical industry. Pfizer CEO, Ian
Read, predicted in 2013 that the number of joint ventures among rivals formed for developing drugs and expanding
into different geographical markets would increase. Read believes the associated benefits from sharing costs, risks, and
commercial benefits are large. In 2013, Pfizer participated in a joint venture with Johnson and Johnson to develop
drugs for Alzheimer’s patients and was contemplating additional ventures. Read cited vaccines, oncology, and
neurodegenerative diseases as potential candidates for future partnerships with competitors, given the growing
pressures to cut costs in drug development as healthcare systems demand increased savings.
Antitrust laws in many countries restrict competitors from collaborating to set prices. However, joint ventures to
share development costs are frequently allowed under existing laws.
Source: A. Jack (2013), “Prizer Chief Looks to Joint Ventures to Bolster Drug Development,” Financial Times (June 6).
Chapter 8 Economics of Strategy: Creating and Capturing Value 267
company’s hardware consisted of property and equipment. However, its most impor- tant asset was its software. McDonald’s major source of value was its new formula for selling hamburgers, fries, and drinks to customers. This formula translated into a business approach that McDonald’s was able to replicate in locations around the world. If McDonald’s had stopped innovating in 1956, new companies that copied and improved on the original formula, such as Burger King, Wendy’s, and Kentucky Fried Chicken, eventually would have forced McDonald’s out of business. But McDonald’s continually improved its formula for creating and capturing value by converting wetware into new software. Today McDonald’s has a much wider product offering, more effective store designs, and better production processes than it had in 1956.
The development of the Filet-O-Fish Sandwich at McDonald’s illustrates the con- version from wetware to software. Originally, the only food products McDonald’s sold were hamburgers and fries. The product line intentionally was limited so that it could be produced efficiently and quickly, according to McDonald’s formula for value creation. A franchisee in a Catholic neighborhood, however, was unable to sell many hamburgers on Fridays because Catholics were admonished from eating meat on Fridays. The franchisee worked hard to develop a tasty fish sandwich. At first, McDonald’s would not let him sell the new sandwich because it was not consistent with the image as a hamburger company. It also would lead to inconsistency across units—something that a franchise company generally wants to avoid. Eventually, however, McDonald’s saw the value that could be created and captured by offering a fish sandwich. Specialists at the corporate level devised ways to improve the sand- wich and to lower production costs (e.g., by using a different type of fish that could be precut into a standard size). Ultimately, the Filet-O-Fish sandwich was introduced across all McDonald’s units and has been a menu staple ever since.
The idea of a fish sandwich initially was contained in the wetware of the franchisee, while the ways to improve the product were in the wetware of specialists at the corpo- rate level. At this stage, the ideas and knowledge were not creating value. But the wet- ware was eventually converted into software and is now part of the McDonald’s for- mula for creating and capturing value. A similar story lies behind the “Big Mac,” which was the brainchild of a franchisee in Pittsburgh who wanted a heftier sandwich to sell to steelworkers.
Software is different from hardware in that it is not a scarce resource. While a given machine can be used only at one location, software can be replicated to create value at locations throughout the world. For example, McDonald’s currently has over 10,000 units operating under the same business format. (Of course, as we will discuss, software also can be copied by competing firms, thus reducing its profit potential.)
Whether or not a firm is likely to be successful in converting wetware into soft- ware depends critically on how decision rights are assigned within the firm and on how employees are evaluated and rewarded (the firm’s organizational architecture). Chapters 11–17 provide a systematic analysis of these considerations.
Opportunities to Create Value
The discovery of better ways to use existing resources drives much of the value that firms create. Today’s personal computers are far more powerful than the 1980s mainframes, yet they take significantly fewer resources to produce. The value cre- ated by improved computer technology has not come from the discovery of new raw
268 Part 2 Managerial Economics
materials or resources, but by using existing resources more efficiently. To quote growth theorist Paul Romer,12
So it is not the raw materials or the mass of things on earth that really lies behind economic success and high standard of living, it is the process of rearrangement. And what underlies this process of rearrangement are instructions, formulas, recipes, and methods of doing things [software].
The possibilities for new value creation are immense. Consider Romer’s simple ex- ample of a production process that involves just 20 steps. The order of the steps can be varied in an extremely large number of ways (approximately 2.4 followed by 17 zeros) and thereby affect the value created. In most production processes, of course, there is a natural ordering that precludes certain combinations of steps—it doesn’t make sense to weld the body together after the car is painted. But given all the ways to rearrange the many resources on earth, the possibilities for continued value creation are enormous. This discussion suggests that firms face an essentially unlimited set of opportunities to create better “instructions, formulas, recipes, and methods” for making improved products at lower cost. New opportunities are likely to emerge as technology continues to evolve. For instance, the latter part of the 20th century saw a massive change in information, communication, and production technologies. This technological change has provided substantial opportunities for increasing value. The “business process reengineering” movement in the 1990s used computer and information technology to lower costs (for instance, by streamlining the systems used to process orders, shipments, payables, and receivables). Flexible production technologies have allowed firms to tailor the design of their products to fit specific customer demands. Computer and information technologies reduce the
M A N A G E R I A L A P P L I C AT I O N S
Sonic Drive-Ins Convert Wetware to Software Sonic Corp. is one of the largest fast-food chains in America with more than 3,500 restaurants in 44 states in 2014.
Former CEO, Pattye Moore, stated in 2002 that she spent half her time visiting stores and eats at Sonic with her
daughters three or four times a week. “We really get a lot of ideas that way. . . . We just go out and ask them what
they’re fixing for themselves. . . . We encourage our employees to play with their food.”
Sonic employees at one store were bored with buns and started eating their burgers and chicken on thick, grilled
toast. Sonic introduced “toaster sandwiches” that became popular with customers. One customer suggested sausage on
a stick wrapped in a buttermilk pancake and deep fried. It is now a breakfast staple. One store manager created the
grilled chicken wrap. All of these products were launched throughout the entire Sonic chain.
Notice how Sonic had encouraged people to experiment with new food dishes (enhancing their wetware) and then
converts this wetware into software. Corporate management then chooses which of these ideas to pursue. The recipes
are refined and codified. Sonic illustrates how one company had used its organizational architecture to convert wetware
at one drive-in into literally new recipes (software) that are leveraged throughout the firm’s other locations. Moreover,
Sonic has a corporate culture that promotes experimentation, identifies potentially valuable wetware, and converts that
wetware into software, which then is leveraged across the firm.
Source: http://corporate.sonic.drivenin.com (2014); and (200), “Required Eating Makes This Job Fun,” Democrat and Chronicle (June 3), 7D.
12Paul Romer (1998), “Bank of America Roundtable on the Soft Revolution: Achieving Growth by Managing
Intangibles,” Journal of Applied Corporate Finance 11(2), 8–27.
Chapter 8 Economics of Strategy: Creating and Capturing Value 269
costs of transacting with suppliers. Using technology to increase value is likely to remain a significant focus well into the future.
Capturing Value Creating value is an essential first step in generating profits. But then it is necessary to capture this value. It does the firm little good to reduce transaction/production costs or to increase consumer demand (for instance, by creating new value- enhancing software) if rivals can copy these changes quickly and enter the market— such competition will eliminate the profits. (But of course, failure to innovate and keep up with the competition can lead to ruin.)
Figure 8.3 compares a firm in a competitive market to a firm with market power. In competitive markets, firms face horizontal demand curves and are price takers. With market power, firms choose price–quantity combinations. Chapters 6 and 7 indicated that firms often can capture value if they exploit their market power. Sometimes firms can capture value, even without market power, if they employ superior factors of pro- duction that allow them to be more productive than their rivals. In a competitive mar- ket, there typically are firms that would be willing to continue to produce the product even if demand and the market price fell. This production corresponds to the dashed section of the supply curve (below the market price P*) in Figure 8.3. Also shown is the corresponding producer surplus. Sometimes (but not always) a firm can capture a portion of this producer surplus as economic profit. Next, we discuss the conditions under which market power and superior resources lead to economic profits.13
$
Qi Qj
Quantity: Industry
Competitive industry
Quantity: Firmi Quantity: Firmj
Market power
P *
Q *
$ Producer surplus
P *
Di
Dj
D
S
Q
$
P ri ce
( in
d o
lla rs
)
Figure 8.3 Firm with Market Power versus a Firm in a Competitive Industry
The firm on the left has a downward-sloping demand curve and thus has market power. It can choose price–quantity combinations. Firms with market power often can capture economic profits. The other firm is in a competitive industry and thus faces a horizontal demand curve. Earning economic profits in this market setting is difficult. Firms along the dotted section on the supply curve (below the market clearing price of P*) still would produce the product if demand and price fell. The shaded triangle represents producer surplus. This chapter discusses how a firm sometimes (but not always) can capture a portion of this producer surplus as an economic profit.
13A note on vocabulary: Economists say a firm is earning rents when it sells its product for a price higher than average total cost (which includes a “normal” rate of return). Positive rents imply that the firm is earning
more than is necessary to motivate it to continue to produce the product over the long run (it is earning an
economic profit). It is useful to distinguish between two types of rents: Monopoly rents, which correspond to our discussion of market power, and Ricardian rents, which correspond to our discussion of superior factors of production.
270 Part 2 Managerial Economics
Market Power
Entry Barriers If there are no barriers to entry, competition from new firms tends to erode profits within the industry.14 Entry barriers exist when it is difficult or uneconomic for a would-be entrant to replicate the position of industry incumbents. These barriers include factors that make price cuts likely if a new firm enters (such as economies of scale), incumbent advantages (such as patents and brand names), and high costs of exit.
Numerous researchers have tested the theoretical link between entry barriers and profit potential.15 Consistent with the theory, these studies generally confirm that price- cost margins tend to be lower in competitive industries. Researchers also have found a positive correlation between profit and specific entry barriers (such as economies of scale or advertising) as well as a positive correlation between profit and concentration (combined market share of the top few firms) across geographic markets within a given industry.16
While theory and evidence suggest that profit potential increases with entry barri- ers, the existence of such barriers is no guarantee of economic profits. There are at least four additional factors that are important. These include the degree of rivalry within the industry, threat of substitutes, buyer power, and supplier power.17
14As discussed in Chapter 6, a firm can have market power when there are limited entry barriers (in the case
of differentiated products—monopolistic competition). Entry, however, often will eliminate or at least
substantially limit economic profits. 15For a survey of some of the relevant studies, see R. Schmalensee (1989), “Studies of Structure and
Performance,” in R. Schmalensee and R. Willig (Eds.), The Handbook of Industrial Organization (North Holland: Amsterdam).
16In apparent contrast to the theory, researchers have failed to document a strong positive correlation between
profits and concentration across industries. This is due in part to the difficulty of comparing accounting data across industries. Cross-industry differences in the treatment of depreciation and other accounting choices
make interindustry comparisons problematic. Another difficulty is that industries can be concentrated for at
least two quite different reasons. First, there can be actual barriers to entry. Second, there can be few firms
in an industry because it lacks profit potential. If the sample contains both types of industries, it is not
surprising that researchers find mixed results. 17M. Porter (1980), Competitive Strategy (Free Press: New York), labels these factors, along with the threat of
entry, as the “five factors.”
Creating but Not Capturing Value: Eli Whitney A great problem in harvesting cotton during the 18th century was separating cotton from its seed. This laborious task
was done by hand. It was so difficult that it took a worker a whole day to clean 1 pound of staple cotton. Eli Whitney,
while visiting Georgia, was intrigued by this problem. Within a few weeks, he produced a machine he called a “cotton
gin” (a shortened form of cotton engine). It greatly increased the amount of cotton that could be cleaned in a day and
soon led to cotton becoming the chief crop in the South. Clearly, the invention of the cotton gin created significant
value. Yet, before Whitney’s invention was completed and patented, his first model had been widely copied. Virtually all
his profits went into lawsuits to protect and enforce his rights. He did, however, make profits in the financial markets
speculating on the price of cotton.
H I S T O R I C A L A P P L I C AT I O N S
Chapter 8 Economics of Strategy: Creating and Capturing Value 271
Degree of Rivalry When the degree of rivalry is high, profits will be low even if there are entry barriers. Two factors that help determine the level of rivalry are the number and relative sizes of competitors. The fewer the number of competitors (the more concentrated the industry), the more likely that firms will recognize their mutual dependence and refrain from cutthroat competition. The presence of a large, dominant firm (as opposed to a comparable number of similarly sized firms) also can reduce rivalry because a dominant firm frequently takes the lead in setting prices and takes actions to sanction others that do not follow its lead (within the limits of antitrust constraints). The level of rivalry can change over time as basic conditions within the industry change. For ex- ample, if existing firms within an industry have excess capacity, they often will engage in price competition in an attempt to increase their individual outputs. In general, ex- cess capacity, high fixed costs, lack of product differentiation, and slow growth all in- crease the degree of rivalry within the industry.
Threat of Substitutes Even if entry is limited, firms within an industry are not immune to outside compe- tition. There is the threat of substitutes. For instance, the large scale of investment potentially limits entry into the overnight delivery market (populated by firms such as FedEx and UPS). However, in recent years effective substitutes, such as e-mail and fax machines, have reduced the demand for delivery services (relative to what would have been without these technological developments). Similarly, banks face competition from money market accounts that offer customers the ability to write negotiable orders of withdrawal (usually restricted to amounts in excess of $100).
Buyer and Supplier Power The final two factors that help determine a firm’s market power are buyer and sup- plier power. If the industry has only a few large customers, profit is likely to be low since these customers will use their buying power to extract lower prices. Simi- larly, if the key suppliers to an industry are large, concentrated, or well organized (e.g., unionized), they will attempt to extract industry profits through high input prices. During the 1990s Intel and Microsoft were essentially sole suppliers of cer- tain key inputs for the production of personal computers; hence they have been quite profitable.
Market Power and Strategy Firms sometimes can increase economic profit by taking actions that promote entry barriers, reduce intra-industry rivalry, limit the availability of substitutes, or reduce buyer/supplier power. Examples of each type of activity are easy to find. For instance, American manufacturers frequently lobby for taxes or restrictions on imports to reduce entry by foreign firms. Firms in certain industries form cartels or other collusive
M A N A G E R I A L A P P L I C AT I O N S
Italian Textiles and Chinese Competition For more than six centuries wool has been cleaned, dyed, and woven in Biella, Italy. Chinese manufacturers once
competed primarily on price, offering low-quality textiles. But now the quality of Chinese textiles has improved
markedly. This has exerted substantial pressure on prices and has led to layoffs and closings in the Italian cloth trade.
Source: C. Rhoades (2003), “Threat from China Starts to Unravel Italy’s Cloth Trade,” The Wall Street Journal (December 17), A1.
272 Part 2 Managerial Economics
agreements to reduce competition.18 As we have discussed, organizations like the AMA act to limit the availability of substitute products or services (in their case new physicians, nurses, physician assistants, and midwives). Firms reduce buyer power by opposing buyer-cooperatives. Finally, firms thwart supplier power by opposing labor unions and expanding capacity in nonunionized locations—especially internationally.
Historically, many managers focused on capturing value through anticompetitive activities, such as erecting entry barriers. They have found that often it is difficult to limit competition—especially in a global marketplace. Also, as discussed in Chapter 21, regulators extract much of the producer surplus created through limits on competition, for example, through campaign contributions to encourage the adoption and enforcement of entry restrictions. Due to these considerations, much of the con- temporary focus in strategy is on superior resources—the subject of the next section.19
M A N A G E R I A L A P P L I C AT I O N S
Competition and the Number of Competitors The degree of rivalry generally increases with the number of competitors. Depending on the nature of the industry,
however, competition can be quite fierce even with only a few competitors. Coca-Cola had about 42 percent of
domestic carbonated soft drink sales in 2014, while Pepsi had a market share of about 30 percent. Yet the battle
between Coke and Pepsi has been intense for decades, with costly promotional contests and intense competition for
distribution. Similarly, competition has been strong in the U.S. tobacco industry, although the three largest companies
have had about 90 percent of the market. In detergents, two large companies, Procter and Gamble and Unilever, have
conducted a global “soap war.” To varying degrees, each of these industries is characterized by excess capacity, high
fixed costs, lack of product differentiation, and slow growth—all factors that lead to greater rivalry.
ANALYZING MANAGERIAL DECISIONS: Investing in a New Restaurant Concept
For the last 10 years you have been working in the
health food business. You have talked to many cus-
tomers who have suggested a new restaurant con-
cept. The restaurant would feature a variety of low
calorie meals (under 500) made from healthy ingre-
dients (e.g., organic fruits and vegetables and
steroid/hormone free meat). The restaurant would
include a bar with an extensive organic wine list
and trendy decor. There would be an emphasis on
high quality, friendly service, and colorful meal
presentation. Your customers suggest that they
would be willing to pay around $50 to eat a meal
and have a glass of wine at this type of restaurant.
They lament the fact that their community has no
upscale restaurants that offer this type of fare.
You have conducted a detailed financial analysis
of this potential business opportunity. You believe
that you have good information on the costs of
starting and operating the restaurant. You project
that with a $50 meal price and anticipated demand
you would earn a high profit and an excellent rate
of return on your investment. You have the equity
capital to start the business.
Several friends with MBAs argue that you would
be crazy to start this business. They claim that there
are few entry barriers to the restaurant industry and
that “every person with business training knows that
you can’t make profits in a competitive industry.”
Should you drop the idea of opening the new
business based on this argument? Explain.
18Managers must be careful undertaking these types of actions in the United States since many are illegal
under American antitrust law. 19Examples of the contemporary focus in the strategy literature are D. Collis and C. Montgomery (1995),
“Competing on Resources: Strategy in the 1990s,” Harvard Business Review, 118–128; and J. Barney and W. Hesterly (2011), Strategic Management and Competitive Advantage: Concepts, 4th Edition
(Prentice Hall: Boston).
Chapter 8 Economics of Strategy: Creating and Capturing Value 273
Superior Factors of Production
Both human as well as physical assets vary in productivity. For example, Clayton Kershaw is a great baseball player, Steve Jobs of the Apple Inc. was a superb CEO, land in California’s Imperial Valley is incredibly fertile, land adjacent to an expressway interchange offers customers quite convenient access, and so on. If an asset allows the firm to make a profit because of its superior productivity, other firms will compete for this resource and bid up its price. Thus, with well-functioning markets, the gains from superior productivity accrue to the responsible asset.
Producer Surplus Captured by Superior Assets Figure 8.1 divides value into consumer surplus and producer surplus. Consumers re- ceive the consumer surplus. Producer surplus goes to the owners of superior assets. As an example, consider Pete Irving, general manager of Speedy Modems. Last year, Speedy was just breaking even in producing modems at a price of $100. Demand for the particular type of modem increased, and the price rose to $150; Speedy began making a profit (producer surplus) of $50 per unit. This profit motivated other firms to produce the same type of modems. They were less productive than Speedy solely because they lacked a manager with Pete’s talents. The rival firms began making job offers to Pete. To dissuade him from going to a rival firm, Speedy had to increase Pete’s salary. Through this process, Pete’s salary increased to the point where Speedy was making only a normal rate of profit—the same as the competing modem com- panies. The gains from his special talents went to Pete, not to the firm. This same process works for physical assets. For instance, if a firm rents a prime piece of land or a unique piece of equipment, rental rates will be bid up to reflect the asset’s supe- rior productivity. And if the firm owns the asset, its value (and thus the opportunity costs for continuing to use it) will be bid up—in effect, the firm pays the rent to it- self for its continued use of the asset.
Figure 8.4 displays a graphical analysis of this general phenomenon. The illustra- tion on the right depicts supply and demand in the marketplace. The initial price is P*0. A typical firm in the industry is depicted on the left and is making no economic profits—price equals long-run average cost (LRAC0). The demand for the product increases and the market price goes up to . The firm appears to have the potential to make an economic profit, since the price is above its initial long-run average cost. Competitors and new entrants, however, will bid for the special resources (such as a talented manager or a productive piece of land) that would allow the firm to produce the product at an average cost below price. In equilibrium, the firm’s costs would
P*1
M A N A G E R I A L A P P L I C AT I O N S
Sugar Prices The 2008 wholesale price for sugar in world markets was about $0.16 per pound. In contrast, the price in U.S. markets
was over $0.26 per pound. The dramatic difference between the two prices is due largely to American tariffs on sugar
imports. Foreign producers would be willing to sell to Americans at lower prices. Yet, they are not permitted to do so.
This restriction benefits domestic sugar producers, who are able to sell their sugar at the higher price. Without entry
restrictions, the U.S. price would be driven down to about $0.16 per pound. Such a domestic price decline would
benefit American consumers but hurt American sugar producers.
274 Part 2 Managerial Economics
increase to the point where its long-run average cost (LRAC1) again equals price. 20
The additional producer surplus created by the increase in price (shaded area) is re- flected in the price or opportunity cost of the scarce assets, which made lower-cost production possible at the initial price and output level.
If the firm owns the scarce asset (e.g., a piece of land), the wealth of the firm’s owners increases as the price of the asset is bid up. It is important, however, to real- ize that a firm does not have to use a superior asset to realize this value. In fact, the firm might be better off selling the assets to another firm. Managers sometimes over- look this alternative.
As an example, it has been argued that British Petroleum (BP) has a competitive ad- vantage in producing retail gasoline because it owns productive oil fields in Alaska that it bought long ago at low prices.21 Potential competitors are disadvantaged, it is argued, because they have to buy oil on the open market at a higher price than BP’s current cost of extracting its oil. This argument is flawed because it fails to apply the concept of opportunity costs appropriately. If BP can sell its oil on the open market, the cost of using it internally is the revenue forgone from not selling it—and that is the current
20This analysis assumes that the asset is equally valuable to all firms. If this assumption does not hold, the
firm’s costs will not necessarily be bid up to the point where it makes no economic profits. Price will not be
bid above the value to the next highest valued user. We discuss this issue next. 21This example is taken from a strategy textbook. Similar examples of faulty analysis are easy to find
throughout the management literature.
Quantity: Market
D0 D1
S
Q
LRAC1
LRAC0
LRMC
$
Qi Q * Q *
P *
P *
Quantity: Firm i
C o st
p e r
u n it
(i n d
o lla
rs )
$
0 Q *01 Q *1
0
1
Figure 8.4 Producer Surplus Is Captured by Superior Assets
The illustration below depicts supply and demand in the marketplace. The initial price is P*0. The typical firm in the industry is depicted on the left and is making no economic profits—price equals long-run average cost (LRAC0). The demand for the product increases and the market price goes up to P*1. The firm appears to have the potential to make an economic profit, since the price is above its initial long-run average cost. Competitors and new entrants, however, will bid for the special resources (such as a talented manager or a piece of land) that would allow the firm to produce the product at an average cost below price. In equilibrium, the firm’s cost would have increased to the point where its long-run average cost (LRAC1) equals price. The additional producer surplus created by the increase in price (shaded area) goes to the scarce assets, which made lower-cost production possible at the initial price and output level.
Chapter 8 Economics of Strategy: Creating and Capturing Value 275
spot market price of oil, not just BP’s extraction cost. If other companies were more ef- ficient in refining crude oil and producing gasoline for retail customers, BP would be more profitable if it sold the oil on the open market and did not compete in the pro- duction of gasoline. The wealth of BP shareholders is certainly greater because the company owns valuable oil rights in Alaska. But the critical question is how do man- agers best exploit this valuable asset. It might be best either to sell the land to another company, sell the oil from the land to another company, or refine the oil internally to produce and sell retail gasoline (or some other petroleum product). Its best course of action depends on the relative efficiency of BP versus its competitors in the extraction and distribution of oil or the production and distribution of gasoline. BP should not ex- tract oil or produce retail gasoline simply because it owns its oil reserves.
Table 8.1 illustrates the difference between accounting and economic profits for BP’s selling gasoline through its own retail gasoline stations. The following assump- tions are used: (1) BP’s cost of extracting enough oil and refining it into a gallon of gasoline is $0.40, (2) this gasoline can be sold on the wholesale market for $2.00, (3) station operating costs (e. g., wages for station attendants) are $2,000,000, (4) BP produces 1 million gallons of gasoline a month, and (5) there are no other relevant costs or revenues, except for $2 million of other retail gasoline operating costs. The top panel shows BP’s income statement using standard accounting techniques as- suming retail gasoline prices of either $4.00 or $3.60. Here the cost for gasoline is
Accounting Profits
Retail gasoline price $4.00/gallon $3.60/gallon Retail sales $4,000,000 $3,600,000 Extraction/refining costs ($400,000) ($400,000) Station operating costs ($2,000,000) ($2,000,000) Profits $1,600,000 $1,200,000
Economic Profits
Retail gasoline price $4.00/gallon $3.60/gallon Retail sales $4,000,000 $3,600,000 Opportunity cost of gasoline ($2,000,000) ($2,000,000) Station operating costs ($2,000,000) ($2,000,000) Profits $0 ($400,000)
Table 8.1 BP Retail Gasoline Stations: Accounting versus Economic Profits
In this hypothetical example, BP’s cost of extracting enough oil and refining it into a gallon of gasoline is $0.40. This gasoline can be sold on the wholesale market for $2.00. It costs $2 million to operate the retail stations (e.g. wages for station attendants). BP produces 1 million gallons of gasoline a month. There are no other relevant costs or revenues, except for the $2 million of other costs to operate the retail gasoline stations. The top panel shows BP’s income statement using standard accounting techniques assuming gasoline prices of either $4.00 or $3.60 per gallon. Here the cost of gasoline is BP’s cost of $0.40 per gallon for extracting oil and refining it into gasoline. BP reports positive profits at prices, $1,600,000 and $1,200,000, respectively. The bottom panel reproduces the income statements using the opportunity cost of the gasoline sold at the stations (its current spot market price). In the latter case, it is better for BP to get out of the retail market and to sell its gasoline (or possibly its land or gasoline) on the wholesale market. It nets $1,600,000 by selling the gasoline in the wholesale market compared to $1,200,000 by selling it through its own stations. BP is indifferent between the two alternatives when the price is $4.00 (in either case, BP nets $1,600,000). This example emphasizes the basic point made in Chapter 5: Managers should make business decisions using opportunity costs, not accounting costs.
276 Part 2 Managerial Economics
BP’s extraction and refining cost of $0.40 per gallon. BP reports positive profits at both prices—$1,600,000 and $1,200,000, respectively. Based on these accounting profits, it might appear that it is profitable for BP to operate its own retail stations. The bot- tom panel reproduces the income statements using the opportunity cost of the gaso- line sold at the stations its market price. Using opportunity costs, BP breaks even when the price of gasoline is $4 but loses money when the price is $3.60. In the latter case, it is more profitable for BP to get out of the retail business and to sell gasoline in the wholesale market (or possibly the land or the mineral rights—this choice de- pends on BP’s efficiency in extracting and refining the oil). BP makes $400,000 more in profits by selling the gasoline wholesale. BP is indifferent between selling gasoline wholesale or retail when the price is $4.00; either way, BP makes $1,600,000 over its production costs. This example illustrates a basic point: Managers should make busi- ness decisions using opportunity costs—not accounting costs.22
Second-Price Auctions Competition tends to take a differentiated asset to its highest valued use, but at a price that reflects its second-highest valued use. In a competitive auction, no one has an incentive to bid more than the value they place on the asset. For example, if Lena Otis is the second-highest valued user of a piece of land, she will bid only up to her value, while José Ricardo, the highest valued user, can obtain the asset by bidding just slightly more. This principle implies that the producer surplus captured by the winning bidder is limited to the difference between the asset’s first and second- highest valued uses; the rest of the value will be reflected in the price of the superior asset.
Team Production Firms consist of collections of assets and explicit or implicit contracts with employ- ees and other parties. For example, at Microsoft, their collection consists of CEO Tim Cook, all his senior managers and employees, the company’s physical assets, brand name, and other intangible assets. Because of the interdependencies among workers and assets, the value of the inputs as a “team”23 sometimes can be greater than the simple sum of the values if each worker and asset were employed at its next best use across other firms. Thus, it is possible that the overall firm will be more valuable than the sum of its parts. We characterize such a firm as having team pro- duction capabilities. A firm can capture value by maintaining team production ad- vantages only if competing firms cannot assemble comparably productive teams. If rivals can, then in a competitive marketplace, the price of the product will be driven down so that the firm makes only a normal profit.
How do firms create team production capabilities that are difficult to duplicate? Part of the answer is a natural consequence of differences in the past histories of firms and the now-sunk choices by managers about goods produced, markets en- tered, individuals hired, and capital acquired. Due to these differences, firms acquire unique combinations of assets, organizational processes, communication channels, col- lective learning, and so on. As environments evolve, some firms find themselves—either
22In Chapter 17, we shall discuss how accounting costs can play an important role in helping to control
incentive conflicts in organizations. 23The word team is used in a variety of contexts in the management literature (e.g., to refer specifically to
small work groups of people). Here, we use the term in a broader sense to refer to a combination of assets
(including human, physical, and organizational assets) used to produce a particular product or service.
Chapter 8 Economics of Strategy: Creating and Capturing Value 277
through luck or foresight—to be in the enviable position of having developed team ca- pabilities that are especially productive in these new circumstances, whereas others do not. For example, Walmart developed an efficient hub-and-spoke distribution net- work to serve its chain of successful rural stores. This system, along with its brand name and procurement advantages, also helped it compete successfully in larger urban areas.
Other firms can observe the team production capabilities of successful firms. Yet, duplicating these capabilities can be difficult because, from the outside, it is frequently difficult to pinpoint the exact source of synergies within the team: Many assets are combined in the typical firm. It also can be expensive to acquire the nec- essary assets (contracting/transaction costs), provide training to workers, and so on. In addition, implementing significant changes within an existing organization presents daunting challenges. That team capabilities often are expensive to dupli- cate is consistent with the observation that many firms enter a new business by buying an existing firm in the industry, rather than by developing the new business within the firm.
Team Capabilities and Organizational Architecture A firm’s architecture consists of its assignment of decision rights and its systems for evaluating and rewarding performance. Organizational architecture is important in contributing to team capabilities. For example, a decentralized firm can respond more quickly and effectively to a new opportunity that requires rapid “front-line” de- cision making (for instance, in competitive pricing to customers) than can a firm with a more centralized decision-making structure. Alternatively, other new opportunities that require detailed coordination of activities across several business units might favor the firm with the more centralized structure. As we shall discuss, it often is hard to copy another firm’s architecture because multiple systems have to be changed in a coordinated manner. Implementing this type of major change within an organization can be surprisingly difficult.
M A N A G E R I A L A P P L I C AT I O N S
Team Capabilities at Sharp Corporation During the 1970s, Sharp began marketing electronic calculators with liquid crystal displays. As the company developed
expertise with LCD technology, Sharp began to apply it to other products, such as television sets. Through these
actions, Sharp developed a set of resources and capabilities that other companies did not have. With the large growth in
consumer electronics and computers during the 1980s and 1990s, potential applications for LCDs expanded rapidly.
Sharp profited from this growth. Other companies could not immediately overcome Sharp’s competitive advantage
because of time constraints and their lack of Sharp’s accumulated assets and experience. Companies such as
Matsushita, NEC, and Canon entered the industry. Yet, Sharp was able to maintain its dominant position because of its
special team capabilities. It continues as a leader in LCD technology; in 2007, Sharp negotiated a major deal with
Toshiba to exchange its LCD sets for Toshiba TV chips. This advantage was not completely captured by its individual
assets in their market values; individual assets would not have allowed other firms to copy Sharp’s advantage. Thus
part of this advantage went to Sharp’s shareholders and was reflected in its stock price. No competitive advantage,
however, lasts forever; in recent years Sharp has been out performed by some of its competitors, including the
Samsung Electronics Company.
Source: D. Collis and C. Montgomery (1997), Corporate Strategy (Irwin: Chicago); and K. Hall (2007), “Sharp and Toshiba: Big TV Tieup,” BusinessWeek.com (December 21).
278 Part 2 Managerial Economics
A Partial Explanation for Walmart’s Success
Sam Walton’s initial strategy in the early 1960s was to establish stores in small towns (populations under 25,000) in rural Arkansas, Missouri, and Oklahoma. His intent was to place “good-sized stores in little one-horse towns, which everybody else was ignor- ing.” As he increased the number of stores, he designed an extremely efficient distribu- tion system—a hub-and-spoke system with regional distribution centers. He also culti- vated key vendor relationships, a distinctive human resource management system, and a nonunionized workforce. As his network of stores increased, he opened additional stores in nearby states, eventually expanding throughout the country and internationally.
As Walmart continued to expand, its success became evident. Would-be competitors envied this success; yet, they did not have the capability to mimic Walmart’s strategy. First, it did not make economic sense for companies to construct competing stores in the small rural communities where Walmart already operated. Surely, the resulting competition with Walmart would drive prices down in these “one-horse” towns. Walmart’s first-mover advantage created an entry barrier and market power. Without a sufficient number of existing stores, it also did not make economic sense to copy Walmart’s distribution system in the rural Southeast. As Walmart gained experience, it developed organizational processes and resources (team capabilities) that provided potential advantages over would-be competitors as it expanded into new geographic areas, such as the Pacific Northwest.
Walmart could have sold some of its resources, such as individual stores, yet potential buyers would have limited incentives to bid up the price of these assets
Flexible Manufacturing and Team Capabilities Economists argue that often it is appropriate to view managerial policies as a system of complements—each policy is
more valuable when it is adopted along with other complementary policies. For example, a fall in the costs of flexible
manufacturing equipment can favor the following simultaneous changes in a firm’s strategy and organizational
architecture: investment in more flexible manufacturing equipment, increased output, more frequent product
innovations, more continuous product improvements, higher levels of training, additional investment in more efficient
production design procedures (computer-aided design), greater autonomy of workers and hence better use of local
information, more cross-training, greater use of teams, additional screening to identify prospective employees with
greater potential, and increased horizontal communication.
Changing only a subset of these policies might be less productive than changing them all at once because of the
complementarities: More value is created when there are reinforcing changes across this collection of policies. For
example, employee training is likely to add less value if employees are not given increased autonomy to employ their
new skills. Yet, making rapid changes in many elements of a firm’s strategy and organizational architecture is
expensive.
Firms in which more of these policies are already in place are more likely to take advantage of a reduction in the
cost of flexible manufacturing than firms without these policies in place. Because of their team capabilities, these firms
are likely to generate economic profits that will not be competed away in the near term.
In this example, the unexpected change in the environment is a fall in the cost of flexible manufacturing technology.
This change benefits some firms but not others. If a different environmental change occurred, a different group of firms
might benefit.
Source: J. Roberts (2007), The Modern Firm: Organization Design for Performance and Growth (Oxford Press: Oxford, UK).
A C A D E M I C A P P L I C AT I O N S
Chapter 8 Economics of Strategy: Creating and Capturing Value 279
ANALYZING MANAGERIAL DECISIONS: Leaving New York City for the Farmlands of Illinois
You have worked as an investment banker in New
York and Hong Kong for the last five years. You are
tired of living in populated cities and yearn for a
more peaceful environment.
The Wall Street Journal contained a story about the federal government’s actions to increase corn-
based ethanol as a substitute for gasoline in the
United States. According to reports, new laws and
regulations will result in the construction of hundreds
of new ethanol factories over the next decade. De-
mand for corn to fuel the plants is expected to soar.
Based on a Web search, you found 80 acres of
prime farmland for sale in Illinois at a price of
$10,000 per acre. You have saved enough from
your past bonuses to purchase the land. You are
tempted to quit your job and purchase the land to
farm corn.
Several colleagues have told you that it sounds
like a good idea. They say that not only would it
allow you to move to a less populated area, but it is
a great business opportunity with little risk. Surely
the price of farmland will increase dramatically
over the next few years as the ethanol plants begin
operation and the demand for corn skyrockets.
Good farmland is limited, and you might reason-
ably expect its price to double or even triple over
the next few years. You are smart and should be
able to learn the farm business very quickly. In ad-
dition, you will have a cost advantage over farmers
who wait to buy land at much higher prices. If you
decide that you do not want to be a farmer, you can
always sell the land at a “huge profit.” Do you
think your colleagues are giving you good advice?
Explain.
unless they could have purchased them all together. For example, the value of an individual store is lower when it is not coupled with Walmart’s distribution sys- tem.24 Thus, although Walmart faced an opportunity cost from not selling its in- dividual assets piecemeal to other firms, the value of keeping these assets together within the same firm was likely to be far higher than this opportunity cost. If Walmart were to construct an income statement based on its opportunity costs (as we did for BP in the bottom panel of Table 8.1), it would show a positive eco- nomic profit.25
Even though Walmart has had a competitive advantage in rural America, its ad- vantage has been smaller in urban centers. Urban areas can support more than one discount store—thus promoting entry by Target, Kmart, and others. There also is more competition from nondiscount stores. Competing firms have copied many of Walmart’s innovations in distribution, vendor relationships, and so on. Thus, in urban areas Walmart has had both less market power and a smaller productivity ad- vantage. Walmart also has had problems at some of its international locations, such as Brazil. Internationally, Walmart’s advantages from superior distribution and ven- dor relations are arguably smaller; also its brand name is less well-known than in the United States.
24A reader might wonder why Walmart couldn’t sell the store to a buyer at a high price and contract with the
buyer to allow it to use Walmart’s distribution system. This issue is addressed in Chapter 19. That analysis
suggests that given the nature of the assets, Walmart is better off owning them jointly. 25Recall that the opportunity costs of the individual resources are their next highest valued use outside of their
current use.
280 Part 2 Managerial Economics
All Good Things Must End
The business environment is constantly evolving with new technological innova- tions, changes in consumer tastes, new business concepts, new firms, and other de- velopments. Given these changes, it is unlikely that any competitive advantage will last forever, unless the firm can find a succession of new value-increasing strategies.
M A N A G E R I A L A P P L I C AT I O N S
Economic Profits without Market Power—A Summary of the Key Concepts Chapter 6 characterized competitive output markets in terms of four basic conditions: (1) many buyers and sellers,
(2) product homogeneity, (3) rapid dissemination of accurate information at low cost, and (4) free entry into and exit
from the product market. In this setting, firms have no market power and essentially are price takers in the output
market: Firm demand curves are horizontal at the market price. The marginal firm sells the product at average cost and
makes no abnormal profit.
In this chapter, we discuss how it is possible for some firms in a competitive market to make economic profits
(produce at an average cost below the market price). Economists refer to these firms as being “inframarginal.” To be
inframarginal, two conditions must be met:
• Rivals cannot imitate the inframarginal firm and assemble teams of assets that produce the product at the same
low cost—at least in the near term. If competitors can erode cost advantages through imitation, competition will
drive the price down and eliminate above-normal profits (rents).
• The full value of the firm’s superior productivity cannot be captured by selling its assets to other firms—unless
they are sold together. Otherwise the opportunity cost of production will be the same as for their rivals (even if
they can’t assemble equally productive teams).
The fact that firms have different histories and paths can help explain the existence of team capabilities and
inframarginal firms. Nonetheless, staying inframarginal is not easy. Potential competitors have strong incentives to
discover ways to imitate successful firms or otherwise counteract their advantages. Also, to the extent that an advantage
is based on an identifiable asset, such as a talented manager or a prime location, the opportunity cost of the resource is
likely to rise from competitive pressures in factor markets. Thus, competitive pressures in both the product and factor
markets make sustaining economic profits difficult.
M A N A G E R I A L A P P L I C AT I O N S
Nomura Securities Company: It Is Not Easy to Remake a Business Japan’s Nomura Securities Company—whose roots go back to the 19th century rice exchanges of Osaka—was one
of the world’s most profitable securities firms in the 1980s. In 1997 following a serious scandal involving payoffs to
racketeers, the company almost collapsed. The company also was hurt because it strongly recommended a set of stocks
to customers that then fell significantly in value. The new president, Junichi Ujiie, vowed to remake the company. He
wanted to deemphasize the selling of individual stocks to customers and focus more on asset gathering and portfolio
advice. His objective was to become more like Merrill Lynch or Morgan Stanley. By late 1999, Ujiie had failed to turn
the company around. Indeed Nomura continued to lose out to smaller competitors in obtaining new business. Between
2000 and 2014, Nomura continued to struggle relative to competitors, such as Goldman Sachs. Its stock fell
significantly during the 2007–2009 financial crisis and it largely failed to recover over the subsequent five-year period.
Like many large companies, Nomura had trouble remaking itself to regain lost success and profitability.
Source: Yahoo Finance (2014), “Nomura Holdings,” finance.yahoo.com; and B. Spindle (1999), “Nomura Restructuring Falters; Can
Mr. Ujiie Still Remake the Firm?” The Wall Street Journal (September 3), A1.
Chapter 8 Economics of Strategy: Creating and Capturing Value 281
M A N A G E R I A L A P P L I C AT I O N S
Walmart’s Strategy Proves Timely during the 2007 Holiday Season Walmart’s experience in the fall of 2007 illustrates how differences in historic paths can give firms a competitive
advantage of disadvantage as the economic environment changes.
The 2007 holiday shopping season was the weakest in five years. Consumer spending fell as consumers worried about
oil prices that approached $100 per barrel and the prospect of economic recession. Relative to the previous year, same-
store sales fell during the holiday season at Target (down 5 percent), Abercrombie & Fitch (2 percent), Gap (6 percent),
Macy’s (7.4 percent), Nordstrom (4 percent), JC Penney (7.5 percent), and Kohl’s (11.4 percent). Walmart was one of the
few retailers with strong performance, experiencing a 2.6 percent increase in same-store sales during the holiday season.
Throughout November and December of 2007, Walmart opened stores very early in the morning on multiple occasions
enticing shoppers with big discounts on products such as high-definition DVRs. Thousands of consumers flooded
Walmart stores in search of bargains. Its emphasis on low prices attracted consumers throughout the holiday season.
Other retail chains, such as Target, scrambled to adapt and offered similar promotions to attract price-focused
customers. These efforts, however, were not as successful as Walmart’s. Walmart was known among consumers for its
historic focus on “everyday low prices.” The historic business strategies of most of the other retailers focused on other
dimensions. For example, Target had developed a reputation for “good design,” while Nordstrom had developed a
reputation for quality products and service. Historic strategies and reputations made it difficult for many of the chains
to convince consumers that they were now focusing on low prices. Costco, which has historically focused on bulk
merchandise and low prices, was one of the few other success stories with a same-store sales increase of 7 percent
(4 percent excluding gasoline sales).
Source: M. Barbaro (2008), “Wal-Mart’s Strategy Proved a Timely One,” nytimes.com (January 11).
Changing Fortunes The fortunes of firms change over time. Due to competitive pressures, the top firms in one period are often not the top
firms in subsequent periods. Below is a listing of the top 10 firms in terms of market value in 1970 and 2013. The lists
are different, only General Electric is on both lists. (Standard Oil of NJ changed its name to Exxon in 1972 and merged
with Mobil in 1999.)
Rank 1970 2013
1 IBM Apple 2 AT&T Exxon-Mobil 3 General Motors Google 4 Standard Oil of NJ Microsoft 5 Eastman Kodak Berkshire Hathaway 6 Sears Roebuck Johnson & Johnson 7 Texaco Wells Fargo 8 General Electric General Electric 9 Xerox Walmart
10 Gulf Oil JP Morgan Chase
Just as the elements erode a mountain, persistent competition erodes firm profits over time. While entry may be limited, outside firms have strong incentives to devise methods of capturing profits from successful firms. Ultimately, one of these methods is likely to work. If one compares today’s top firms with those of, say, 50 years ago, the lists are quite different. For example, today’s top firms like Google, Microsoft, Walmart, and Apple did not exist 50 years ago, whereas many of the top firms from yesteryear have become less successful or gone out of existence.
282 Part 2 Managerial Economics
Consistent with this view, Walmart’s growth slowed significantly during the first part of the 1990s. Although its performance improved during the late 1990s, eco- nomic theory and experience suggested that continued superior performance should not be expected over the long run.
Economics of Diversification Although the New York Times Company, concentrate on a single major business, most large firms engage in numerous businesses: They are diversified. This raises the question: Is corporate diversification a productive strategy to create and capture value? Economies of scope are the primary reason that diversification might enhance value. In addition, combining businesses within the same firm can promote comple- mentary products. But diversification also entails costs. Value maximization requires that firms consider both the benefits and the costs of diversification. In this section, we discuss these costs and benefits and analyze the circumstances under which di- versification is most likely to create value. We also examine who is most likely to capture this value.
Benefits of Diversification
Economies of Scope As discussed in Chapter 6, economies of scope exist when one firm could produce multiple products at lower cost than separate firms could produce the products. Economies of scope might occur anywhere along the vertical chain of production.26
Consider the following examples: A diversified firm buys inputs at a discount re- flecting its higher volume from using the same inputs in producing different products; a firm economizes on transportation costs because it delivers different
Polaroid’s Success and Ultimate Failure to Capture Value From 1948, when Polaroid introduced its first instant camera, until 1972, when it unveiled its SX-70, the company
continually improved its almost magical product. The first Polaroid camera produced sepia-toned prints, but over the
years the company developed the ability to produce color photos that materialized right before one’s eyes. In 1972,
Polaroid’s stock price was 90 times earnings, propelling the company into the Nifty Fifty (the top 50 companies in the
Fortune 500). But the SX-70 was followed by a series of flops, including Polavision, a moving version of instant photography that was inferior to video. Moreover, the development of digital imaging provided an alternative method of
viewing pictures immediately and precipitated Polaroid’s Chapter 11 bankruptcy filing in October 2001. It stopped
making cameras in 2007 and in 2009. The history of Polaroid illustrates two important points. First, successful firms
develop new wetware that leads to innovative products, which satisfy customers’ demands. Second, competition—often
arising from new technologies—erodes the profitability of companies that, on a continuing basis, fail to innovate
successfully.
Source: D. Whitford (2001), “Polaroid, R.I.P.,” Fortune (November 12), 44; http://en.wikipedia.org/wiki/Polaroid_Corporation.
26The vertical chain of production consists of the various steps in taking raw materials and transforming them
into consumer products. These steps include research and development, purchasing, production, outbound
logistics, marketing, sales, service, support activities, and so on. See Chapter 19 for a more detailed
discussion of this chain of activities.
Chapter 8 Economics of Strategy: Creating and Capturing Value 283
products to the same customer; a firm uses salespeople more efficiently because they are able to offer customers an array of products; and a firm economizes on flotation costs because it raises capital to fund several businesses at once. Some- times, producing one product unavoidably also produces others because of a joint- ness in the production process. For instance, if a firm produces beef by slaughter- ing cows, it also frequently makes economic sense to produce other products with the bones and hides.
Combining activities inside the same firm is not the only way to achieve these types of economies. There are alternative ways to organize that also accomplish this objective. For example, an independent wholesaler might offer retailers an array of products produced by separate manufacturers, centralize the billing of retailers, and provide a more efficient inventory and distribution system. Which method of organi- zation is best depends on contracting costs. For example, negotiating and enforcing contracts among independent firms can be expensive, as can organizing activities within the same firm (see below). Sometimes integrating activities within the same firm is less expensive than contracting among firms. In this case, diversification cre- ates value. We discuss the trade-offs in choosing among organizational forms in greater detail in Chapters 11–17 of this book.
Promoting Complements Another potential reason for diversification is to promote the supply of complementary products. For example, Ford and General Motors entered the consumer credit business in 1919 and 1959, respectively.27 One potential benefit of auto manufacturers’ entering
M A N A G E R I A L A P P L I C AT I O N S
Walmart Diversifies into the Traditional Grocery Store Business In 1998, Walmart opened three “experimental” 40,000-square-foot grocery stores in Arkansas. The potential benefits of
this diversification derive from economies of scope. Walmart has a quite efficient distribution system that also can be
used to stock the grocery stores. It has the potential to leverage its relationships with key vendors, which currently
serve its discount stores and supercenters. Walmart’s management has significant experience in managing stores in a
related business. This experience is likely to be helpful in choosing store locations, establishing and running
management systems, and so on.
M A N A G E R I A L A P P L I C AT I O N S
McFocus at McDonald’s McDonald’s decided to shed at least some of its sideline ventures into pizza, fast-casual Mexican food, and takeout
dining and concentrate on revitalizing its core hamburger business. McDonald’s had gotten into Chipotle Mexican
Grill, Donatos Pizza, and Boston Market to offer its best franchisees expansion opportunities and to find new growth
vehicles. But neither goal has been achieved. “We cannot allow anything to distract our owner-operators, suppliers, and
company people from maximizing the full potential of Brand McDonald’s,” said CEO Jim Cantalupo.
Source: R. Gibson (2003), “McDonald’s May Exit from Ventures,” The Wall Street Journal (November 10).
27See G. Stigler (1966), The Theory of Price, 3rd edition (Macmillan Press: London).
284 Part 2 Managerial Economics
the financing business would be to increase the demand for automobiles by offering low- interest-rate loans to customers (recall Figure 8.1).28 Contracting/transaction costs also were reduced because the consumer could fill out the loan application while purchasing the automobile. Today, communication systems, computers, and sophisticated credit- scoring systems make it easy to apply for a car loan from a lender over the phone or the Internet. This was true in neither 1919 nor 1959. Again there may have been other ways of organizing to achieve these economies (e.g., the automobile companies could have contracted to process loan applications for a bank). However, the costs of these organi- zational alternatives evidently were higher than combining the businesses within one company.
As another illustration, recall our example of PCs and printers. The companies benefited by coordinating the pricing of their products; another way of achieving this cooperation would be to merge the two firms.
Costs of Diversification
Although diversification has potential benefits, it also has potential costs. As firms grow, they often become bureaucratic and more expensive to manage. As we shall discuss in more detail in later chapters, it is difficult to devise compensation plans that motivate managers in large companies to behave like owners of smaller compa- nies. Owners have a natural incentive to work hard and increase the value of their firms because they keep the profits of the firm, whereas salaried managers do not. If diversification occurs through the merger of two firms (as is often the case), it also can be quite expensive to develop common personnel, communication, information, and operating systems.
Management Implications
A Faulty Reason to Diversify Some managers diversify to reduce earnings volatility. For example, the former CEO of Goodyear Tire justified diversification into the oil business because it was coun- tercyclical to the tire industry. He reasoned that when gas prices were low, the com- pany would do well in tires, since people would be driving more. When gas prices were high, the company might do poorly in tires but would do well in the oil busi- ness. Overall, earnings would be less volatile.
It is true that diversification can reduce earnings volatility. The problem with using this as a justification for diversification is that this reduction in volatility need not in- crease a firm’s value. Shareholders (the owners of public companies) can diversify within their own investment portfolios at low cost. For example, it is easy for investors to purchase shares of both a tire company and an oil company. Through this diversifi- cation investors reduce return volatility on their overall portfolios. There is no reason
28Offering low-interest-rate loans benefited Ford and GM only if their cost of providing credit to customers was
lower than the prevailing market price for credit (e.g., the loan market was noncompetitive or the auto company
valued repossessed cars from bad loan customers more than other lenders). Otherwise, the companies could
have obtained the same increase in sales by simply reducing the price of automobiles by the amount of the credit
subsidy. (However, note that the credit subsidy might make it easier to price-discriminate between cash and
credit customers. Low-interest rates might be used to hide price concessions to credit customers.) See S. Mian
and C. Smith (1992), “Accounts Receivable Management Policy: Theory and Evidence,” Journal of Finance 47, 169–200.
Chapter 8 Economics of Strategy: Creating and Capturing Value 285
for investors to pay a premium for a company simply to reduce return volatility, since they can achieve this same objective by purchasing stock in the two separate compa- nies.29 At the same time the costs of integrating diverse businesses within the same firm can be significant.
When Does Diversification Create Value? Related diversification occurs when the businesses serve common markets or use re- lated technologies. For example, Disney Corporation operates theme parks, hotels, retail shops, and television stations. In each of these industries, Disney concentrates on employing its strong brand name to market family-oriented products. Their brand name reduces transaction costs to consumers in their search for quality products ap- propriate for children.
Net benefits are likely to be greater in related rather than unrelated diversification. If there is little interaction on either the production or demand side of the businesses, it is hard to envision where economies of scope might arise and by definition the two businesses would not produce complementary products.30 An example of unrelated diversification is the decision by KinderCare Learning Centers, a day-care manage- ment firm, to enter the savings and loan business; it subsequently entered bankruptcy.
Value is increased only when the benefits of diversification are larger than the costs. There is a significant body of research on the value consequences of diversification.31
For the most part, diversified firms have not performed well. Indeed, many of the large conglomerates during the 1980s, such as ITT and Tenneco, increased their values by divesting units (through sales and spinoffs) and refocusing on a more narrow line of businesses. Research documents that 55.7 percent of exchange-listed firms had a sin- gle business segment in 1988, compared to 38.1 percent in 1979. More importantly, the research shows that this increase in focus was associated with higher stock returns.32
Diversification has been most effective in the case of related diversification where there are potential economies of scope and opportunities to promote complements.33
Who Captures the Gains from Diversification? Even if diversification creates value, the owners of the diversified firm do not always capture this value. Again, it depends on whether the firm brings some special re- source or team capability to the transaction. If it does not, the value is likely to be captured by another party due to competition. Consider the potential benefits of
29Although managers generally should be skeptical of the proposition that reductions in earnings volatility
increase value, there are cases where the proposition is true, for example, if reducing earnings volatility
reduces expected taxes or the costs associated with financial distress. See C. Smith and R. Stulz (1985), “The
Determinants of Firms’ Hedging Policies,” Journal of Financial and Quantitative Analysis 20, 391–405. 30Some managers assert that their management skills are so good that they can create value in any business.
Although this may be true, it is obvious that a given management team has limited capacity in the number
of businesses the team can manage. Again, one might expect value to be maximized if the businesses are
related. 31See J. Barney (1997), Gaining and Sustaining a Competitive Advantage (Addison-Wesley: Reading),
388–389, for a summary of this research. There are, however, examples of a few firms that appear to have
created value through unrelated diversification. 32R. Comment and G. Jarrell (1995), “Corporate Focus and Stock Returns,” Journal of Financial Economics 37,
67–87. This issue of the Journal of Financial Economics contains several other interesting articles on “corporate focus.”
33There are some exceptions to this general finding. For example, General Electric is quite diversified and runs
a variety of rather unrelated businesses. Nonetheless, it has performed extremely well.
286 Part 2 Managerial Economics
merging a television cable company with a long-distance telephone company. Sup- pose that there is one cable company with the rights to operate in a specific area, whereas there are several long-distance telephone companies. Competitive bidding among the telephone companies would imply that the phone company that valued it the most would get the cable company at a price equal to its value to the second-place phone company. This process would give most of the value gains to the owners of the cable company: They own the unique resource. Consistent with this example, sub- stantial research documents many cases where target firms obtain most of the gains in corporate takeovers.34
Strategy Formulation Developing and implementing strategies that increase a firm’s value require an un- derstanding of both the internal resources and capabilities of the firm and its external business environment.35 Figure 8.5 displays these two factors.
Understanding Resources and Capabilities
An important first step in strategy development is understanding the firm’s resources and capabilities. By resources and capabilities, we mean the firm’s physical, human, and organizational capital. This includes the firm’s hardware, software, and wetware; specifically, those activities which the firm can do better than other firms—its team production capabilities. It also is important to understand the opportunity costs of using these assets within the firm. For example, how much would they be worth if they were sold to other firms?
Understanding the Environment
As depicted in Figure 8.5, important factors in the business environment include the firm’s markets (both input and output), technology (production, information, and
M A N A G E R I A L A P P L I C AT I O N S
Diversification Problems at Xerox During the 1980s Xerox diversified into financial services. The company had gained experience in finance through the
leasing of its copy machines, and management believed that by acquiring firms in the financial sector, it could leverage
this experience. In late 1982, Xerox purchased a property/casualty insurance company, Crum and Foster, for $1.6 billion.
This acquisition was followed by other acquisitions in life insurance, real estate, and investment banking.
With minor exceptions, this diversification turned out to be a financial drain on Xerox. The economies of scope were
not as great as had been hoped and problems in the financial businesses distracted top management from Xerox’s main
business—copiers. In the 1990s Xerox repositioned itself as the “document company” and sold its financial businesses to
other companies. As of 2014, Xerox remained focused on providing business process and document solutions.
34See G. Jarrell, J. Brickley, and J. Netter (1988), “The Market for Corporate Control: The Empirical Evidence
since 1980,” Journal of Economic Perspectives 2, 49–68, for a summary of this research. Note, however, that it is more difficult to identify gains to acquiring firms than acquired firms: 1) Acquiring firms are generally
much larger than acquired firms so even if merger gains were split evenly, they would be a much smaller
percentage change in value of the acquirer, and 2) acquirers frequently have merger programs and are involved
in a series of acquisitions, thus expected merger gains are capitalized into the acquiring firm’s stock price. 35A variety of approaches to strategic management are discussed in the strategy literature. The framework
outlined in this section is most consistent with the “strengths, weaknesses, opportunities, and threats” approach.
See J. Barney (1997), Gaining and Sustaining a Competitive Advantage (Addison-Wesley: Reading).
Chapter 8 Economics of Strategy: Creating and Capturing Value 287
communications), and government regulation. Effective managers monitor the busi- ness environment to keep abreast of new developments in each of these areas.
Referring to Figure 8.1, managers must understand the business environment to identify opportunities for value creation. For example, what technological opportu- nities exist to reduce costs? It would be a poor decision to invest in an expensive technology to lower costs, if forecasted technological innovations are expected to make the investment obsolete soon. What opportunities exist to reduce consumer or producer transaction costs? Managers must have a detailed understanding of how transactions take place in the marketplace to discover ways of reducing transaction costs. What opportunities exist for improving consumer products? Are there ways of promoting complementary products? Are there potential industries in which the firm could leverage its resources and capabilities? Are there opportunities to create value through cooperating with other firms?
An understanding of the firm’s environment also is important for identifying op- portunities for, as well as threats to, capturing value. For example, what opportunities are there to block entry or the development of substitutes? What threats loom from potential substitutes, buyer power, supplier power, and industry rivalry?
Combining Environmental and Internal Analyses
Most resources and capabilities are finite—choices must be made. For example, firms have limited production capacity and human resources. Thus, they face trade- offs in deciding how to use these resources and in deciding whether it is worth the
INTERNAL RESOURCES AND CAPABILITIES
Physical Capital
Human Capital
Organizational Capital
BUSINESS ENVIRONMENT
Markets Input Output
Technology Production Information Communication
Government Regulation
STRATEGY
Figure 8.5 Framework for Strategic Planning
Members of the management team should have a good understanding of their firm’s internal resources and capabilities before they modify their strategies. They also should understand their external business environment. The objective is to use this knowledge to discover ways of creating and capturing value.
288 Part 2 Managerial Economics
investment to supplement them. Also managers must decide whether it is best to use their marketable assets within the firm or whether to sell them to other firms. These strategic choices require managers to combine environmental and internal analyses: They must understand both their internal strengths and weaknesses, as well as the threats from and opportunities within their business environment. Typi- cally, strategies do not remain constant, but evolve through time. It usually is im- portant for managers to consider how other economic agents in the business envi- ronment will react to their strategic decisions (e.g., rival firms, suppliers, and buyers). In Chapter 9 we examine this issue in detail.
In deciding how best to use special resources and capabilities, it is important to be forward-looking. Sometimes it is more profitable to invest in complementary re- sources and capabilities that allow the firm to exploit its unique position better in the future. For example, it might have been profitable for Sharp to invest in acquiring com- plementary knowledge about computers and other technologies to supplement the firm’s skills in LCDs.
Strategy and Organizational Architecture
To be successful, a company must have not only a good strategy, but also an ap- propriate architecture. Ultimately, both strategy and organizational architecture are key determinants of value. Chapters 11–17 of the book presume that the strategy of a firm has been determined and present a detailed analysis of how a firm’s environ- ment and strategy influence its organizational architecture. This approach is reason- able because the organizational design often is based on what the firm wants to do strategically. For example, if a firm adopts a strategy to react quickly to customer de- mands, it will probably have to design a decentralized decision system with accom- panying performance evaluation and reward systems to motivate productive deci- sions. Figure 8.5, however, emphasizes that the effects are not all in one direction. A firm’s architecture also can influence its strategy—it is an important part of the firm’s internal resources. For example, if the firm has a well-functioning, decentral- ized decision-making system, it is more likely to enter markets for which this type of organizational design is well suited.
M A N A G E R I A L A P P L I C AT I O N S
A Retail Success Story and Luck IKEA, one of few retailers that has flourished on foreign soil, had 233 stores in 34 countries selling $14.8 billion a year
worth of furniture in 2005. Its strategy is that well-designed furniture can be inexpensive without being ugly. IKEA
entered international commerce by chance. Started in Sweden in the 1960s, local Swedish retailers pressured Swedish
manufacturers to cut off supplies to the upstart IKEA. In response, IKEA turned to Poland for supplies and was
surprised to find that it could buy well-crafted furniture more cheaply. This transformed IKEA into thinking about
foreign suppliers and retail markets. The firm now has spread to Asia and North America. IKEA is a very patient firm.
While trying to figure out how to please U.S. shoppers, IKEA absorbed losses for years. They “had to learn that
Americans expected jumbo beds and didn’t think in centimeters.”
Source: J. Hagerty (1999), “How to Assemble a Retail Success Story,” The Wall Street Journal (September 9), A24; K. Capell (2006), “IKEA’s New Plan for Japan,” BusinessWeek (April 26).
Chapter 8 Economics of Strategy: Creating and Capturing Value 289
ANALYZING MANAGERIAL DECISIONS: Walmart.com
Conventional wisdom holds that to succeed in
electronic commerce, you have to get in early.
But in late 1999, Walmart decided to challenge
that most sacred of web rules. After several years
of tinkering with its website, watching while
others broke new Internet ground, the retailing
giant was ready to flex some cyber muscle. Up
to that point, Walmart.com had realized modest
success online, ranking 43rd among Internet
shopping sites. It trailed web pioneers like eBay
and Buy.com. In May 1999, Amazon.com greeted
almost 10 million online visitors; Walmart.com
saw only 801,000. For 1999, analysts expected
Walmart’s e-commerce activities to produce sales
of less than $50 million out of the company’s total
sales of $157 billion.
Walmart faced increasing direct competition
from Amazon.com. In July 1999, Amazon
announced its expansion from books, music,
and videos into toys and consumer electronics.
Walmart already was a powerhouse in these
product categories through its traditional stores.
It announced that it would offer products from all
25 categories carried in a typical Walmart discount
store. Moreover, it expected to offer a broader
array of higher-priced items than its traditional
stores—for instance, DVD players and digital
cameras. It also enabled customers to return
products ordered online to any of Walmart’s 2,451
U.S. discount stores. Like Amazon, it planned to
provide tailored online specials to match the
shopping habits of its repeat customers.
The company announced plans to expand its
online store offerings before the end of 1999 to
match more closely the breadth of its traditional
outlets. To facilitate this expansion, Walmart
penned deals with Fingerhut Business Services and
Books-a-Million. Both had expertise in distributing
individual orders directly to customers’ homes—
quite a different set of skills from bulk shipments,
which had been Walmart’s forte.
Demographic shifts occurring in cyberspace
offered the potential to help Walmart. Back in
1999 Jupiter Communication projected e-retailing
to grow from approximately $12 billion in 1999 to
an estimated $41 billion in 2002. Much of this
expansion would be concentrated in Walmart’s
existing lower- and middle-class customer base.
Jupiter analyst Kenneth R. Gasser noted, “Internet
users are increasingly coming to resemble the
population at large.”
By 2005, Walmart.com had logged $1 billion of
Internet sales. However, the world’s largest retailer
only ranked about 13th in Internet sales while
Amazon.com had sales of over $10 billion. About
500 million total visitors clicked on Walmart.com in
2005, and the company predicted this to increase
to 700 million in 2006. But, its online sales still
only accounted for about 1 percent of Walmart’s
annual sales.
In January 2007, Walmart.com launched
Soundcheck, an original series of musical perfor-
mances that feature punk pop and rock bands to
increase its digital music offerings. In March
2007, Walmart.com announced “Site to Store”
where Walmart.com shoppers can purchase online
and have orders delivered to their local store for
free. By July, Site to Store sales more than dou-
bled since its March rollout, and about 90 percent
of participating stores had at least one Site to
Store order within the first 48 hours of service
activation. In January 2008, only 11 months after
initiating its movie download service,
Walmart.com quietly dropped this service
because Hewlett-Packard Co. stopped providing
the application that allowed shoppers to purchase
and download videos such as movies and TV
shows.
Placing yourself back in 1999, answer the following
questions in a well-developed discussion:
1. What is the impact of Walmart.com on
customer-borne transaction costs?
2. Do you think that Walmart.com is likely to
create additional value?
3. Is it likely that Walmart will capture any value
created by Walmart.com?
4. Should Walmart have pursued e-commerce
more aggressively sooner?
5. What do you think the potential impact of
Walmart.com will be on the company’s efforts
to expand internationally?
290 Part 2 Managerial Economics
Can All Firms Capture Value?
Consultants often suggest that any firm can develop a strategy that produces economic profits, even if it does not begin with unique resources or team capabilities. What is necessary is that the manager be a “visionary” and make sound investments in devel- oping the skills and capabilities to compete successfully in the future. (Of course, for a fee these gurus would be happy to help the manager accomplish this objective.)
Basic economics suggests that these consultants are wrong. Even if a manager is exceptional at predicting the future and seeing what resources and capabilities are important, abnormal profits will not be earned on a systematic basis so long as there are other managers who follow the same strategy.36 Competition will bid up prices of the required resources in the factor markets and bid down prices in the output mar- kets. As in any competitive market in equilibrium, the expected outcome is a normal rate of return—not sustained abnormal performance.
Although some managers may be better at systematically predicting the future, luck plays a key role in the acquisition of valuable resources. Under this view, many firms invest in projects that before the fact are expected to yield normal returns. These firms take somewhat different paths in their investment strategies, develop- ment of internal processes, hiring decisions, and so on. As time passes and environ- ments change, some firms find themselves with superior resources and team capa- bilities, whereas others do not. It takes managerial talent to identify whether or not the firm has valuable resources and capabilities and to decide how best to use them to maximize returns. Managers easily might think they have unique resources and capa- bilities when in fact they do not.37
Firms without special resources or capabilities at best can expect to earn a normal rate of return on their investment. Firms whose resources and capabilities do not fit the changed environment should not expect to earn a normal rate of return and might prepare to go out of business.38 In a competitive environment, it can take significant managerial effort and talent (devoted to decisions like choosing products as well as producing and marketing them efficiently) just to earn a normal return.
6. In November 2007, Walmart.com announced
that it wants to be “the most visited, most
valued online retail site.” Suppose you were
hired by an outside consulting firm to evaluate
Walmart.com’s potential to achieve this goal.
Write a short report listing those factors that
will enhance and those factors that will
impede Walmart.com’s ability to achieve
the goal of “the most visited, most valued
online retail site.”
Source: W. Zellner (1999), “When Wal-Mart Flexes Its Cybermuscles,” BusinessWeek (July 26), 82; S. Murphy (2007), “The Walmart.com Way,” Chain Store Age (July), 80; www.internetretailer.com; and www.today.msnbc.msn.com/id/21940867.
36Even if no other manager were to have this skill, it still would not be clear that the firm would capture the
gains: It is the manager who owns this unique resource. 37See M. Ryall (1998), “When Competencies Are Not Core: Self-Confirming Theories and the Destruction of
Firm Value,” working paper, University of Rochester. 38H. Kim and J. Schatzberg (1987), “Voluntary Corporate Liquidations,” Journal of Financial Economics 19,
311–328. This article documents that, on average, shareholders incur significant financial gains around the
announcements of voluntary liquidations. Apparently, the stock market is unsure that managers will make
the tough decision to liquidate poorly performing firms and is happily surprised when liquidation
announcements are made.
Chapter 8 Economics of Strategy: Creating and Capturing Value 291
Summary Strategy refers to the general policies that managers employ to generate value. Rather than focus on operational detail, a firm’s strategy addresses broad, long-term issues facing the firm. Ultimately, along with its organizational architecture, strategy is a key determinant of the success or failure of the enterprise.
The ultimate objective of strategic decision making is to realize sustained prof- its. To achieve this objective, managers must devise ways to create and capture value. An essential first step in generating profits is discovering ways to create value. There are at least four general ways that managers can increase value: (1) They can take actions to lower production costs or producer transaction costs. (2) Managers can implement policies to reduce consumer transaction costs. (3) They can adopt strategies to increase demand. Demand might be increased by taking ac- tions to increase perceived quality, lower the price of complements, or increase the price of substitutes. (4) They can devise new products or services. Sometimes more value is created by cooperating with firms than by competing against them. Suc- cessful firms find ways to convert ideas and knowledge in their employees’ wetware into software—formulas and recipes for creating value.
The discovery of better ways to use existing resources drives much of the value that firms create. For example, the value created by improved computer technol- ogy has not come from the discovery of new raw materials or resources, but by using existing resources more efficiently. Firms face an essentially unlimited set of opportunities to create better “instructions, formulas, recipes, and methods” for making improved products at lower cost. New opportunities are likely to emerge as technology continues to evolve.
Creating value is a necessary first step in making profits. It is also necessary to capture value. A firm may have reduced its transaction/production costs or increased its consumer demand, but if other firms copy these changes quickly and enter the market, the competition will eliminate the profits. Chapter 6 indicates that the po- tential for firms to capture value increases with market power. Sometimes it also is possible to capture value without market power if the firm has superior factors of production that allow it to be more productive than competitors.
The existence of effective entry barriers is required for market power. Entry barri- ers exist when it is difficult or uneconomic for a would-be entrant to replicate the posi- tion of industry incumbents. The existence of barriers, however, is no guarantee of market power or economic profits. At least four other factors are important: The degree of rivalry within the industry, threat of substitutes, buyer power, and supplier power.
Both human as well as physical assets vary in productivity. If an asset allows the firm to make a profit because of its superior productivity, other firms will compete for this resource and bid up its price. Thus, in a well-functioning market, gains from su- perior productivity go to the responsible asset. For example, if a firm owns a unique piece of equipment, its price will be bid up to reflect its superior productivity. The firm itself does not always have to use such assets to realize its values. It might earn more profits by selling or leasing the assets to other firms.
Competition tends to take a differentiated asset to its highest valued use, but at a market price that reflects its second-highest valued use. Because of the interdepen- dencies among employees and assets, the value of the inputs as a team sometimes can be greater than the sum of their values if each were employed at their next best uses across other firms. Thus, it is possible that the overall firm will be more valu- able than the sum of its parts. We characterize such a firm as having team produc- tion capabilities. A firm can maintain team production advantages only when com- peting firms cannot assemble teams that are equally productive. Firms develop
292 Part 2 Managerial Economics
different team capabilities because they have different histories and development paths.
The business environment is constantly evolving with new technological develop- ments, changes in consumer tastes, new business concepts, new firms, and so on. Given these changes, it is unlikely that any competitive advantage will last forever.
Some firms concentrate on a single major business, but many large firms engage in multiple businesses: They are at least partially diversified. Economies of scope provide the primary reason why diversification might enhance value. In addition, combining businesses in the same firm can promote complementary products. Al- though diversification has potential benefits, it also has potential costs. As firms grow, they often become bureaucratic and more costly to manage. If diversification occurs through the merger of two firms (as often is the case) it also can be quite ex- pensive to develop common personnel, communication, information, and operating systems.
Some managers diversify to reduce earnings volatility. This often is a poor rea- son to diversify because shareholders can diversify on their own account simply by owning the shares of multiple companies. Related diversification occurs when the businesses use related technologies or serve common markets. The net bene- fits are likely to be greater in related rather than in unrelated diversification. For the most part, highly diversified firms have not performed well. Diversification has been most effective in the case of related diversification where there are po- tential economies of scope and opportunities to promote complements. Even if di- versification creates value, the owners of the diversified firm do not always cap- ture this value. Again, it depends on whether the firm brings some special resource or team capability to the transaction. Historically, most of the gains in corporate acquisitions go to the shareholders of target firms.
Developing and implementing strategies that increase a firm’s value require an understanding of both the internal resources and capabilities of the firm and the ex- ternal business environment. A firm’s resources and capabilities include its physical, human, and organizational capital. Important factors in the business environment in- clude the firm’s markets (input and output), technology (production, information, and communications), and government regulation. Managers monitor the external envi- ronment to identify threats and opportunities for creating and capturing value.
Most resources and capabilities are finite—choices have to be made. To make op- timal choices, managers must consider the firm’s resources and capabilities jointly, as well as threats and opportunities within the external business environment. Ulti- mately, the firm’s strategy, along with its organizational architecture, is a key deter- minant of a firm’s value.
Strategy consultants often suggest that all firms can develop strategies that de- liver systematic economic profits even if they do not begin with unique resources or team capabilities. Basic economics suggests that this claim is false. Even if a man- ager were good at predicting the future and seeing what resources and capabilities were important, abnormal profits would not be earned on a systematic basis so long as a sufficient number of other managers adopt the same strategies. If multiple man- agers adopt the same strategy, there will be competition in the output markets as well as in input markets to obtain the necessary resources and capabilities. As in any competitive market, the expected equilibrium outcome is a normal rate of return— not sustained abnormal performance. Firms whose resources and capabilities do not fit the changed environment will not expect to earn a normal rate of return; they should prepare to go out of business.
Chapter 8 Economics of Strategy: Creating and Capturing Value 293
D. Besanko, D. Dranove, S. Schaefer and M. Shanley (2012), Economics of Strategy (Wiley: New York).
A. Brandenburger and B. Nalebuff (1996), Co-opetition (Doubleday: New York).
D. Collis and C. Montgomery (1995), “Competing on Resources: Strategy in the 1990s,” Harvard Business Review, 118–128.
M. Porter (1980), Competitive Strategy (Free Press: New York).
P. Romer (1998), “Bank of America Roundtable on the Software Revolution: Achieving Growth by
Managing Intangibles,” Journal of Applied Corporate Finance 11(2): 8–27.
8–1. Racket Sports Inc. has invented a new long-lasting tennis ball, but only if the players use a new type of string in their rackets. The racket string is produced by the Strings and Things
Company. The respective prices for the balls and strings are PB and PS. The marginal cost of producing either product is $5. Demand for each product is
Q � 20 � (PB � PS) when (PB � PS) less than 20 or less, 0, otherwise
How will the two companies price the products if they do not cooperate? What are the resulting
quantities and profits? What are the prices, quantities, and profits if the two companies price
cooperatively? Explain why there is a difference.
8–2. Opportunity Cost and Competitive Advantage
The average price of jet fuel in March 2008 was $3.10 per gallon. In 2000 the price was only
$0.87 per gallon. During this time period, Southwest Airlines hedged the price of fuel in finan-
cial markets. The hedge contracts helped “lock” Southwest Airlines into lower fuel prices—as
the price of fuel increased, so did the value of their financial contracts. Roughly speaking, if
the price of fuel increased at $1.00 per gallon, the financial contracts paid Southwest Airlines
$1.00 per gallon, which effectively allowed them to purchase fuel at the price before the in-
crease. Leading financial analysts argued that these hedges gave Southwest Airlines a competi-
tive advantage over airline companies that had not hedged fuel prices. To quote one,
Southwest Airlines has a competitive advantage in the Texas market because of its fuel hedges. Its fuel costs only a $1.00 per gallon, while other airlines are paying $3.00. We do not see how these other airlines can continue to compete with Southwest on most of its routes.
Do you agree with the analyst’s statement? Explain.
Solutions to Self-Evaluation Problems 8–1. If the two companies do not cooperate in setting prices, each will seek to maximize its indi-
vidual profits, given its expectation about the other firm’s price. In this case, Racket Sports
will view its demand curve as:
PB � (20 � PS*) � Q
while Strings and Things will view its demand curve as:
PS � (20 � PB*) � Q
where PB* and PS* represent the expectations about the other firm’s price. Each firm will maximize its profits by setting MR � MC ($5 in this problem).
Racket Sports: (20 � PS*) � 2Q � 5
Strings and Things: (20 � PB*) � 2Q � 5
Substitute Q � 20 � (PB � PS) and rearranging the terms yields the following two equations:
(20 � PS*) � 2[20 � (PB � PS)] � 5
(20 � PB*) � 2[20 � (PB � PS)] � 5
Self-Evaluation Problems
Suggested Readings
294 Part 2 Managerial Economics
The equilibrium consists of the two prices that simultaneously solve these two equations.
Note that in this problem the two firms face identical problems (they face the same expected
demand curve and marginal cost). Thus in equilibrium, they will choose the same prices,
PS* � PB* � P*. Substituting and solving one of the equations:
(20 � P*) � 2 [20 � (P* � P*)] � 5
3P* � 25
P* � $8.33
Each firm sells a total of Q � 20 � (8.33 � 8.33) � 3.33 units. The profit margin on each unit is $8.33 � $5 � $3.33. The total profits per firm are $11.11 (9�3 � 9�3) and combined profits of $22.22.
If the two firms cooperate they will price the two products to maximize combined profits.
To maximize combined profits, the companies will jointly set marginal revenue equal to
marginal cost using the combined demand curve PC � 20 � Q and marginal cost � $10, where PC � the combined price of (PB � PS):
20 � 2Q � $10
They sell 5 units at a combined price of $15 (e.g., PS* � PB* � $7.50) for a combined profit of $25 [� 5 � ($15 � $10)]. When the firms price independently, they do not consider the negative effect that their higher prices have on the other’s profit. Pricing cooperatively, they
take this interaction into account.
8–2. The analyst’s comment is not consistent with sound economic analysis. Southwest makes money on its financial contracts when fuel prices increase. This revenue helps to increase its
profits relative to the profits of airline companies that do not have similar hedging contracts.
However, Southwest still faces the same opportunity cost for fuel as other airlines—the market
price. In deciding whether or not to fly a particular route, Southwest should consider the mar-
ket price of fuel in its profit forecasts. It makes money on the financial contracts whether it
flies the route or not. The marginal cost for fuel is the current market price. Either Southwest
has to purchase additional fuel in the market to fly the route or use fuel that it has in inventory
that could be sold to other airlines at the market price. Either way the opportunity cost of fuel is
the current market price.
8–1. Choose a company that markets computer products over the Internet (e.g., through a Web search). In what ways does the company create value? Is it likely to capture much of this
value? Explain.
8–2. Airbus and Boeing are two major producers of jumbo jets. Are these firms guaranteed to make high profits since there are only two large firms in the industry? Explain.
8–3. The Watts Brewing Company owns valuable water rights that allow it to produce better beer than competitors. The company sells its beer at a premium and reports a large profit each
year. Is this firm necessarily making economic profits? Explain.
8–4. What are team capabilities? Give examples of firms that appear to have them.
8–5. Sun Resorts has a hotel on a Caribbean Island. It recently spent money to lobby the govern- ment to build a better airport and expand air service. Why did they do this? Do you think
that Sun Resorts cares about how many airlines will serve the island? Explain.
8–6. Evaluate the following statement: “Business is war. Never consort with the enemy.”
8–7. The Long-Drive Golf Company manufactures a new line of golf clubs. The Cushion Bag Company makes a special golf bag that protects the delicate shafts on these clubs. The re-
spective prices are Pc and Pb for the clubs and bags. The marginal cost for producing either product is 100. Demand for each product is
Q � 1,000 � (Pc � Pb) when Pc � Pb is 1,000 or less, 0, otherwise
Review Questions
Chapter 8 Economics of Strategy: Creating and Capturing Value 295
How will the two companies price the products if they do not cooperate? What are the
resulting quantities and profits? What are the prices, quantities, and profits if the two
companies price cooperatively? Explain why there is a difference.
8–8. One CEO justified the merger of his soft-drink company with a machine tool company in the following manner: “This is a great merger. First the products are unrelated. Thus our
company’s earnings volatility is likely to decrease. Second, our management team has
proved that we are better managers than the former management team of the tool company,
and thus we are likely to discover new ways to create and capture value within the tool
company.” Evaluate this rationale.
8–9. Pepsi produces Fritos and Lays potato chips in addition to its basic soft-drink products. Discuss potential ways that this business combination might increase value.
8–10. The Strippling Drug Company has just obtained an important patent for a new drug that increases male virility and cures male pattern baldness at the same time. Does this imply
that Strippling has a competitive advantage in producing the drug? Explain.
chapter
9 C H A P T E R O U T L I N E
Game Theory
Simultaneous-Move, Nonrepeated Interaction
Analyzing the Payoffs
Dominant Strategies
Nash Equilibrium Revisited
Competition versus Coordination
Mixed Strategies
Managerial Implications
Sequential Interactions
First-Mover Advantage
Strategic Moves
Managerial Implications
Repeated Strategic Interaction
Strategic Interaction and Organizational Architecture
Summary
Appendix: Repeated Interaction and the Teammates’ Dilemma
T he Boeing Company and Airbus Industrie (a consortium of four European firms) manufacture most of the world’s large commercial jetliners.1 In 2003 Airbus delivered more jetliners than Boeing for the first time in its 34-year history. With just two major companies
in the market, one might expect that the firms would cooperate regularly, avoiding competition in order to increase prices and profits. In actuality, these companies frequently compete quite aggressively.
The choice between cooperation and aggressive competition is determined in part by the nature of the environment. For example, cooperation is more likely in circumstances where each firm is near capacity. But in 2001, Airbus orders had fallen by 28 percent and Boeing by 45 percent. These reductions mirrored the growing crisis in the airline industry. Airline losses were soaring in the face of declining demand for air travel in response to the combination of the slowdown in the global economy and the September 11, 2001, terrorist attacks. This was recognized in Morgan Stanley’s August 12, 2002, research report on Boeing. It suggests “an already tough pricing environment gets
Economics of Strategy: Game Theory
1Details for this example are from A. Bryant (1997), “The $1 Trillion Dogfight,” New York Times (March 23), 3.1; M. Freudenheim and J. Tagliabue (1998), “Regulators Investigating Price Increases
by Boeing and Airbus,” New York Times (November 27), C.1; and D. Michaels (2004), “Airbus Zooms Past Boeing, but Strong Euro Poses a Threat,” The Wall Street Journal ( January 16), A9; and S. DuBois (2013), “Boeing vs. Airbus: Can’t We All Just Get Along?” Fortune Magazine (March 19).
L E A R N I N G O B J E C T I V E S
1. Define game theory. 2. Understand simple diagrams that depict games in strategic (normal) form. 3. Define dominant strategy. 4. Explain the economics of a prisoner’s dilemma and provide examples of how
these dilemmas can arise within firms.
5. Determine (pure strategy) Nash equilibria in simple two-person games. 6. Define mixed strategy and describe why managers might sometimes choose to
use one.
7. Understand simple diagrams that depict sequential games in extensive form. 8. Apply backward induction to find the equilibrium in two-person sequential
games.
9. Define first-mover advantage. 10. Describe the key managerial insights obtained from game theory.
Chapter 9 Economics of Strategy: Game Theory 297
tougher if Airbus needs to fill slots available.” Competition has continued to be in- tense in subsequent years. In 2013, Airbus and Boeing waged a “brutal price war to access emerging markets and to roll out new aircraft.” In the 10-year period from 2004 to 2013, Boeing received 8,428 orders, while delivering, 4,458 planes, com- pared to Airbus that had 8,933 orders and 4,834 deliveries.
Many of the world’s markets are like the commercial aircraft industry in that there are a few large firms who are the major players. Examples include soft drinks (Coke and Pepsi), U.S. domestic airlines (American, United, and Delta), copy machines (Canon and Xerox), candy (Hershey and Mars), and smartphones (Apple and Samsung). Even small firms often compete with an identifiable set of rivals and can act as the major players within a given market area. Consider two competing gasoline stations at an expressway interchange.
In this type of market, it generally is important for managers to consider rivals’ re- sponses when making major decisions. For example, part of Airbus’ marketing plan in the late 1990s was to be overtly negative toward Boeing. One Airbus brochure de- picted the Boeing 777 as an aging stretch limousine painted like a yellow taxicab, while the Airbus craft was pictured as a Mercedes luxury sedan. In another ad, Air- bus pointed out that the Boeing 737 entered service in 1968, the same year Richard Nixon first was elected president of the United States. Perhaps not surprisingly, Boe- ing produced negative advertisements of its own. In choosing its advertising policy, Airbus presumably had to consider whether a negative campaign would be value- maximizing given Boeing’s likely response. Similarly, Boeing had to consider Air- bus’ response in choosing its actions.
Game theory provides a useful set of tools for managers to use when considering rival responses in decision making. This chapter presents a more detailed discussion of the basic theory and shows how managers might use these tools in strategic decision making. This analysis also provides managers with a richer understanding of competi- tion within different market settings. For example, it provides insights into why there is fierce competition in some concentrated industries (such as commercial aircraft), whereas in others the competition is more benign. Although we focus primarily on interactions among rival firms in product markets, these concepts also are useful to managers when dealing with other parties, such as suppliers, employees, or government officials.
Game Theory Game theory is concerned with the general analysis of strategic interaction.2 It focuses on optimal decision making when all decision agents are presumed to be rational, with each attempting to anticipate the likely actions and reactions of its
2The terms strategy and strategic are used in at least three related yet slightly different ways in the economics literature. In all three contexts, the decision maker is assumed to interact with others in the environment. Thus
the optimal decision is affected by the actions of others. The focus of the analysis, however, varies among the
three uses. First, the terms are employed to refer to the general policies that managers use to generate profits.
The traditional strategy literature tends to use the terms within this context (e.g., what businesses should the
firm be in and how should they compete?). Even though rival responses are in the background in this literature,
they are not explicitly treated in the analysis. Second, the terms are used to refer more specifically to decision-
making contexts where it is essential for managers to consider the behavior of identifiable rivals in choosing
their policies (e.g., in setting prices in an industry with a few large firms). This is the primary use in this
chapter. Third, they also are used in a more formal sense in game theory to describe the players’ actions in a
given game (e.g., to describe a player’s “strategy” in playing a game). We introduce this usage and related
concepts in this chapter.
rivals.3 Although it began as a set of methods to analyze parlor games, this theory has evolved to the point where it is applied to study a wide variety of strategic in- teractions ranging from politics to competitive strategy. In this chapter, we intro- duce its basic elements and apply them in the context of managerial decision making.
Sound managerial decision making often requires “putting yourself behind your rivals’ desk.” Assuming rivals are rational and acting in their self-interest, what deci- sions are they likely to make and how are they likely to respond to your actions? A complicating factor is that rivals’ optimal choices typically will depend on their ex- pectations of what you will do; their expectations, in turn, depend on their assess- ments of your expectations about them. This type of circularity or recursive thinking might appear to make the overall problem completely intractable. Yet, this situation is precisely where game theory is most useful.
Strategic interactions can take a variety of forms and involve many players who choose among a variety of potential actions. In this chapter, we limit ourselves to simple two-player, two-action cases. This limitation allows us to depict strategic problems using convenient diagrams. The fundamental intuition and concepts de- veloped in these basic cases readily extend to multiple players and multiple ac- tions. Some problems involve simultaneous decisions by rivals, whereas others in- volve sequential choices. We begin by examining strategic problems involving simultaneous choices. Later, we consider sequential problems. In some cases, in- teraction is expected to be repeated; in others, it is not. Throughout most of this chapter, we focus on problems where the interaction is not expected to be repeated. Toward the end of the chapter—and in the appendix—we consider implications of repeated interaction.
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3Game theory is divided into two branches. In cooperative games, players can negotiate binding contracts that allow them to plan and implement joint strategies. In this chapter, we focus on noncooperative games, where negotiation and enforcement of binding contracts is not possible. This type of game theory generally is more
useful for analyzing managerial decision making.
Game Theorists Win the Nobel Prize The Nobel Prize for Economics (or, more precisely, The Bank of Sweden Prize in Economic Sciences in Memory of
Alfred Nobel) is the world’s most prestigious award for contributions to the field of economics. It is awarded annually
by the Royal Swedish Academy of Sciences. The prize consists of a gold medal, a diploma bearing a citation, and a
sum of money—$1.3 million in recent years. It represents the ultimate recognition by one’s peers.
In 1994, John Harsanyi, John Nash, and Reinhard Selten won the prize “for their pioneering analysis of the theory
of noncooperative games.” And again in 2005, game theorists Robert Aumann and Thomas Schelling received the prize.
Their contributions have had an important impact not only on theoretical economics, but also on business practice.
Firms hire game theorists as consultants in formulating strategic decisions (e.g., in government auctions, corporate
takeovers, pricing, labor negotiations, and competitive positioning). Several best-selling business books have illustrated
how game theory can be used in everyday business decisions. Game theory now is being taught within most major
business schools. And for those who do not want to take a course or read a book, the movie A Beautiful Mind—based on Sylvia Nasser’s award-winning biography of John Nash—won three Oscars in 2001, including Best Picture. (Note,
however, that the movie’s illustration of a Nash equilibrium is fundamentally flawed.)
A C A D E M I C A P P L I C AT I O N S
Chapter 9 Economics of Strategy: Game Theory 299
Simultaneous-Move, Nonrepeated Interaction In strategic problems that involve simultaneous moves, rivals must make decisions with- out knowledge of the decisions made by their competitors. Nonrepeated means that the interaction is presumed to occur only once.4 As an example, suppose that Boeing and Airbus are asked to submit sealed bids on the price of 10 jet airliners to a foreign na- tional airline. Both companies doubt that they will compete in similar ways in the future. Both companies can submit either a high price or a low price. If one company bids high and the other bids low, the order goes to the low bidder; if both companies submit the same bid, they split the order. Each firm has the capacity to build all 10 airplanes.
Analyzing the Payoffs
Both companies privately submit their bids at the same time. The resulting payoffs (profits expressed in millions of dollars) depend on both firms’ choices; they are displayed in Figure 9.1. This type of diagram presents the potential payoffs from the in- teraction in what is called strategic form (also called normal form). Each cell presents the payoffs in millions of dollars for a pair of decisions. The entry on the lower right of each cell is the profit for Airbus, and the entry on the upper left is for Boeing.5
4Many competitive situations have a logical sequencing of events (one company sets a price and others react)
and repeat interaction. By starting with simple simultaneous, nonrepeated games, we can more easily explain
the basic analytic tools used in game theory. The basic insights from this analysis can generally be extended
to more complex situations. 5This diagram has two primary columns and two rows. Boeing is the row firm in the sense that its strategies
vary between the two rows. Airbus is the column firm in that its strategies vary across columns. We place the
payoff to the row firm at the upper left of the cell and the payoff to the column firm in the lower right. An
alternative way to picture the payoffs is a simpler 2 � 2 table with each row representing one of Boeing’s
potential actions and each column representing one of Airbus’ potential actions. The entries in each cell of
the table would list the payoff to Boeing and to Airbus, respectively (e.g., 100, 0). Although this alternative
is more common (possibly because it is easier to type), students seem to find diagrams like 9.1 easier to read.
Both diagrams display the same information.
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Figure 9.1 Strategic Form
In this case, Boeing and Airbus individually choose and simultaneously submit a bid price for 10 planes. They can submit either a high price or a low price. If one company bids high and the other bids low, the order goes to the low bidder; if both companies submit the same bid, they split the order. This diagram presents the possible profits from the interaction in strategic form (normal form). Each cell presents the payoffs (in millions of dollars) of a pair of decisions. The entry on the lower right of each cell is the payoff for Airbus, whereas the entry on the upper left is for Boeing. Both firms have a dominant strategy (shaded cell)—submit a low price.
Dominant Strategies
A dominant strategy exists when it is optimal for a firm to choose that strategy no mat- ter what its rival does. In Figure 9.1, both firms have a dominant strategy—submit the low price. To illustrate, consider Boeing’s position. If Airbus submits a high price (the right column), Boeing captures the entire order by submitting a low price. The resulting payoff of $1 billion is higher than the payoff of $750 million if both firms price high and split the order. If Airbus submits a low price (the left column), Boeing is clearly better off to price low and split the order. Its alternative is to price high and sell no planes. The same logic holds for Airbus. Given these strong incentives, the likely outcome is for both firms to submit a low price. Note that the firms would be better off if they jointly were to submit high prices. But this outcome is unlikely without repeated interactions. This problem has the same structure as the prisoners’ dilemma introduced in Chapter 6—in this context, we might call it the rivals’ dilemma. As we shall see, a “cooperative” outcome where both firms submit high prices without explicit collusion is more likely if their interaction is expected to be repeated.
This logic helps explain why Boeing and Airbus frequently compete aggressively on price. Airline orders frequently are measured in billions of dollars, so each sale is important. Further, customers (normally commercial airline companies) have eco- nomic incentives to deal with a single major supplier of aircraft since this policy re- duces the required inventory of spare parts, technician training (maintenance per- sonnel work only on one make of plane), and so on.6 Thus if Boeing or Airbus lose an order, it implies the loss of potential future orders as well. Just as in Figure 9.1 the companies have strong economic incentives to submit low bids to capture orders.
Boeing and Airbus have particularly strong incentives to compete on price be- cause each firm has the capacity to produce additional output. Boeing has stated that
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M A N A G E R I A L A P P L I C AT I O N S
Stocklifting—A Dominant Strategy? Manufacturers frequently compete for shelf space in retail stores. Some spend hundreds of thousands of dollars to
purchase products produced by competing firms to clear shelf space for their products. The merchandise, purchased in
these “stocklifting” transactions, is later sold through product liquidators at large losses.
Makers of everything from bicycle chains to party napkins have lifted truckloads of competitors’ products from
large retail chains such as Kmart and major drugstores. Other stocklifting examples include cell phones, power
adapters, leather cases, pet toys, humidifiers, flashlights, faucets, and glue. The stocklifted merchandise is subsequently
“dumped” for resale by faraway (sometimes foreign) retailers. The purpose in each case is to clear shelf space for the
stocklifter’s products.
From the standpoint of the manufacturer this costly practice is a potentially dominant strategy. To quote one product
manager, “It costs a ton of money; however, if you want to land a major retail account, you’re going to have to do it.”
When competing manufacturers jointly engage in this practice, they can find themselves in a “rivals’ dilemma”
such as in our Boeing/Airbus example: They would each be better off if no one stocklifted. Given the private incentives
of each firm, however, stocklifting is difficult to avoid. For instance, after purchasing stocklifted products from a
company, some liquidators make sales calls to the victims, encouraging them to “return the favor” by working with
their companies.
6Given these considerations, our assumption that if the bids are the same, the order is split between Boeing and
Airbus should be questioned. Yet, if the buyer flips a coin and gives all the order to the lucky bidder whenever
the bids are equal, then the expected payoffs are the same as in Figure 9.1.
Chapter 9 Economics of Strategy: Game Theory 301
it wants to win two-thirds of all new orders (substantially above its current level), whereas Airbus wants to win about 50 percent (approximately equal to its current level). These conflicting goals promote price competition as each firm tries to take orders from the other. If the rivals faced tighter capacity constraints, to engage in ag- gressive price competition. For instance, in our simplified example, a firm clearly would not want to lower the price to capture the full order if it lacked the capacity to produce all 10 planes.
Nash Equilibrium Revisited
Firms do not always have dominant strategies. For instance, suppose in our example that the U.S. government places pressure on the foreign country to have its national airline purchase planes from Boeing (governments sometimes do this for their domestic producers). The airline still splits the order when the bids are the same and awards Boeing the entire order if Boeing is the low bidder. But due to this political pressure, if Boeing bids high and loses the bid, the airline will buy four planes from Boeing at the high price on a side deal after purchasing the 10 planes from Airbus at the low price. Figure 9.2 presents this new payoff struc- ture. Submitting a low price is still a dominant strategy for Airbus. Boeing, however, does not have a dominant strategy. If Airbus submits a high price, it is optimal for Boeing to submits a low price to capture the entire order, whereas if Airbus submits a low price, it is better for Boeing to submit a high price and make the side deal.
Nash Equilibrium When dominant strategies do not exist, the concept of a Nash equilibrium is useful in predicting the outcome. A Nash equilibrium is a set of strategies (or actions) in which each firm is doing the best it can, given the actions of its rival. In Figure 9.2, the com- bination of a low Airbus price and a high Boeing price is a Nash equilibrium. Neither firm would want to change its price given the price submitted by the other firm.
A particular problem might have multiple Nash equilibria. Nash equilibria are not necessarily the outcomes that maximize the joint payoff of the players. For in- stance, in Figure 9.1 the outcome where both firms submit low prices is a Nash equilibrium. Yet both firms would be better off if they were to collude and jointly submit high prices.
Are Nash Equilibria Likely? Researchers have conducted many laboratory experiments on how people act in strategic situations. One particular
question of interest is Do they choose Nash equilibria? The evidence suggests that the concept works relatively well in predicting behavior in simple single-move situations—especially if the individuals have prior experience interacting
in similar ways with different partners in the past. It appears to work less well in more complex situations (e.g.,
situations that involve sophisticated mathematical calculations) and in repeated situations (we discuss implications of
repetition later in this chapter). Also it often fails where coordination is required and there are multiple equilibria,
unless there is a natural focal point.
Source: D. Davis and C. Holt (1993), Experimental Economics (Princeton University Press: Princeton).
A C A D E M I C A P P L I C AT I O N S
Identifying a Nash Equilibrium The circle technique provides a simple way to identify a Nash equilibrium in such a problem. Consider the case in Figure 9.2. Start by assuming that Boeing will submit a low price (this is in the top row). Circle the maximum payoff that Airbus can achieve. This payoff (labeled #1) is in the cell where Airbus submits a low price (if the same payoff were to occur regardless of whether Airbus submits a high or low price, circle both cells). Second, move to the bottom row and assume that Boeing submits a high price; again circle Airbus’ higher payoff (#2). Third, assume Airbus submits a low price (left column) and circle Boeing’s higher payoff (#3). Finally, move to the right column and assume Airbus submits a high price; circle Boeing’s higher payoff (#4). If a Nash equilibrium exists, the payoffs in both halves of the cell will be circled. In this problem, the Nash equilibrium is the shaded cell where Boeing submits a high price and Airbus submits a low price.
Dominant strategies also can be identified by this technique. If the firm has a dom- inant strategy, the strategy will be circled for all actions by the rival firm. In this
302 Part 2 Managerial Economics
Figure 9.2 Nash Equilibrium
Boeing and Airbus individually submit prices for 10 planes. They can submit either a high price or a low price. If one company bids high and the other bids low, the order goes to the low bidder; if both companies make the same bid, they split the order. If Boeing loses the bid, it sells four planes at the high price through a side deal. The circle technique provides a simple way to identify a Nash equilibrium. Start by assuming that Boeing will submit a low price (the top row). Circle the maximum payoff (in millions of dollars) that Airbus can achieve. This payoff (labeled #1) is in the cell where Airbus submits a low price (if the same payoff were to occur regardless of whether Airbus submits a high or low price, circle both cells). Second, move to the bottom row and assume that Boeing submits a high price; circle Airbus’ higher payoff (#2). Third, assume Airbus will submit a low price (left column) and circle Boeing’s higher payoff (#3). Fourth, move to the right column and assume Airbus submits a high price; circle Boeing’s higher payoff (#4). If a Nash equilibrium exists, the payoffs in both halves of the cell will be circled. In this game, the Nash equilibrium is where Boeing submits a high price and Airbus submits a low price—shaded cell. (Note: Airbus has a dominant strategy—submit a low price—the low-price strategy is circled in both rows.)
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Chapter 9 Economics of Strategy: Game Theory 303
example, submitting a low price is a dominant strategy for Airbus: For each of Boe- ing’s possible actions submitting a low price is circled.
Management Implications The power of a Nash equilibrium to predict the outcome in strategic situations stems from the fact that Nash equilibria are self-enforcing: They are stable outcomes. For instance, if Boeing can forecast Airbus’ choice (perhaps because it understands that Airbus has a dominant strategy), it is optimal for Boeing to choose its equilibrium ac- tion, a high price. And Airbus has no incentive to avoid its equilibrium choice, a low price. Thus, even if both firms can accurately forecast the outcome, neither firm has an incentive to choose any other action.
Although the idea of a Nash equilibrium is quite useful, it is not as powerful in predicting the outcomes of strategic interactions as is the concept of a dominant strategy. When dominant strategies exist, there are strong private incentives to choose them, regardless of what the other player does. Thus, it is quite predictable that rivals will choose dominant strategies. With a Nash equilibrium, your best choice generally is contingent on what you expect your rival to do.
In many cases it is reasonable to expect that a Nash equilibrium will occur. This is more likely to be true when the rivals have more experience in similar strategic prob- lems, have better information about each other, or when the Nash equilibrium is what is called a natural focal point.7 For example, consider the problem in Figure 9.2. If Boeing has reasonable information about potential payoffs and Airbus’ lack of political power within the specific country (it understands that there is a close working relation- ship between the local and U.S. governments), it will realize that Airbus has a domi- nant strategy to submit a low price. Boeing correspondingly will choose a high price— the Nash equilibrium. When rivals know little about the game or each other and when there is not a natural focal point, outcomes other than Nash equilibria (nonequilibrium outcomes) are more likely to occur.
Competition versus Coordination
To this point, we have analyzed competitive interaction. In each case, at least one of the firms has an incentive to submit a low bid to take sales from the other and garner additional profits. This potential gain comes at the expense of the other firm. Many strategic situations, however, involve coordination rather than competition.
Consider the problem in Figure 9.3, in which Boeing and Airbus make simulta- neous choices of new communication systems for their planes.8 Two technologies
7A focal point exists when there is a reasonable and obvious way to behave. To illustrate how a Nash equilibrium
could be a focal point, consider a game where two strangers are asked to raise a hand. Both players receive
a large payoff if they stick up the same hand (both left hands or both right hands) and nothing if they
raise opposite hands. Two Nash equilibria exist: (1) both raising left hands, (2) both raising right hands.
Nonequilibrium outcomes occur when the players raise opposite hands. The Nash equilibrium of both
raising right hands is potentially a focal point. Most people are right-handed. If one player expects that the other
is likely to raise his right hand because he is right-handed, she will have the incentive to raise her right hand as
well. Reciprocally, it is reasonable for the other player to follow the same logic. Thus this outcome is potentially
much more likely than either the nonequilibrium outcomes or the Nash equilibrium of two left hands. 8For example, suppose each company is working to introduce a new intermediate-capacity plane at next year’s
Paris Air Show and each views its choice of communication technology as a critical selling point for its
model. Each will have to commit to a technology at the design phase, and each might be reluctant to discuss
such features with its rival before the new model is unveiled.
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Figure 9.3 Coordination Game
Boeing and Airbus make simultaneous choices of new communication systems for their planes. Two technologies exist: Alpha and Beta (payoffs in millions of dollars). Both firms benefit if they choose the same technology. Applying the circle technique, we can see that there are two Nash equilibria: Alpha/Alpha and Beta/Beta (shaded cells).
ANALYZING MANAGERIAL DECISIONS: Favoring a Government Ban on Advertising
Cigarette manufacturers were among the first
companies to advertise extensively on television.
Older people today can still hum the heavily
televised jingle, “Winston tastes good like a
cigarette should,” and recall the Old Gold Dancing
Cigarette Pack—an oversized dancing cigarette
package with shapely female legs. They can also
remember beautiful women with black eyes as
they testified that “Tareyton smokers would rather
fight than switch.” John Wayne and other movie
stars appeared in commercials to endorse
cigarettes. Cigarette companies were the major
sponsors for many popular television shows. The
companies also paid to have cigarettes included in
the actual programs. In 1962, the cartoon charac-
ters Fred and Wilma Flintstone were shown
smoking Winston cigarettes.
The U.S. federal Government banned television
advertising of cigarettes starting in 1971. Interest-
ingly the ban was supported by the leading cigarette
manufacturing companies even though they had
advertised heavily on television since the 1940s.
1. Design a simple two-company game that illus-
trates why it might have been in the economic
interests of the cigarette companies to support
the ban. In designing the game, assume that
there is no regulation and that the two firms
simultaneously choose between advertising
and not advertising. Display your hypothetical
payoffs in strategic form (see Figure 9.1) and
highlight the Nash equilibrium. Explain the
intuition for why the firms in your example
would favor regulation to ban advertising.
2. Can you conclude from your example that
all firms in all industries will favor bans on
television advertising? Explain. Can you ever
envision a situation where one firm might favor
the ban and a competing firm might be against
it? Discuss.
exist: Alpha and Beta. Both firms benefit if they choose the same technology. A common technology standard allows producers to exploit scale economies and in- creases the likelihood that other companies will invest to develop new enhance- ments for the system because they can sell to both companies. Similarly, compa- nies are more likely to develop service capabilities and stock larger inventories of
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M A N A G E R I A L A P P L I C AT I O N S
Coordination Problems with High Definition Televisions When combined with a good sound system, HDTV can provide a theater-like experience. The introduction of HDTV into
the marketplace was slowed by coordination problems between television networks and manufacturers. Both groups
thought that they would benefit by the development of this product. However, neither wanted to be the first to commit.
Network executives were quoted as saying that they were reluctant to move forward with plans for new programming
until the television manufacturers committed themselves to producing enough affordable sets to receive it. Yet
manufacturers did not want to commit until the networks indicated that there would be enough digital programming for
consumers to want to buy the sets. The situation was summed up in 1997 by a senior executive at CBS, “The networks are
waiting to see what the TV makers are going to do, and the TV makers are waiting to see what the networks are going to
do.” In this situation, there are two Nash equilibria: Manufacturers and broadcasters both invest or neither invests. Due to
coordination problems, firms may “get stuck” in the second equilibrium, even though both groups prefer the first.
Although development of HDTV was slowed by coordination problems, it became a commercial reality by 1999.
Manufacturers were selling the sets and broadcasting companies were providing more and more HDTV programming (the
first equilibrium). Nonetheless, for HDTV to become a widely adopted product, available programming had to increase
and set prices had to decline. Their initial prices for the sets ranged from about $5,000 to $10,000.
The coordination problems illustrated in this example arise frequently with new technologies. The overall value of a
technology is usually higher when there are many users (there are network effects) and there is a common standard
(e.g., consider how much less valuable DVDs would be if there were several different incompatible formats and only a
small number of users of any one type). Adopting a uniform standard can be difficult when there are numerous players
with somewhat conflicting interests. Sometimes governments, joint ventures among firms, and industry trade groups
play a constructive role in promoting common standards, thereby helping to realize a preferred equilibrium. For
example, in December 1996 the Federal Communications Commission set a timetable for stations and manufacturers
converting to digital technology and, in October 2005, the Senate Commerce Committee set April 7, 2009, as the last
date at which U.S. television stations can broadcast analog signals.
Source: J. Brinkley (1997), “Networks and Set Makers in Standoff over HDTV,” New York Times (August 29), 5; and J. Kerr (2005), “Senate Looks to Spend $3B on Digital TV,” WashingtonPost.com (October 20).
spare parts. The overall demand for planes also might be higher because airlines would have lower costs in learning a single system.
Applying the circle technique, we can see that there are two Nash equilibria: Alpha/ Alpha and Beta/Beta. If precommitment communication is possible, it is quite likely that one of these equilibria will be reached. For instance, if both firms an- nounce that they will choose Alpha, there is no private incentive to deviate from this choice. Coordination can prove more difficult in cases where precommitment com- munication is costly and/or there are many players.
Some strategic interactions involve elements of both competition and coordination. In the interactions problem in Figure 9.4, Boeing and Airbus benefit from choosing the same technology; again, there are two equilibria. But the companies are not indif- ferent between the two. Boeing prefers the Alpha technology, whereas Airbus prefers the Beta technology (the technologies are better matches for their particular aircraft design). Coordination in this setting can be more difficult than in pure coordination problems, since the firms want different outcomes. Nonetheless, if one of the firms is convinced of the choice the other firm is going to make, it has an economic incentive to follow suit and choose the same technology. Below we discuss ways that firms might be able to make credible statements regarding their upcoming choices.
Mixed Strategies
In the strategic problems we have examined thus far, firms have chosen one specific action (e.g., a high or low price). This type of choice is known as a pure strategy. Sometimes it can pay to randomize; for example, choose a high price with probability p and a low price with probability 1 � p. The benefit of this so-called mixed strategy derives from the element of surprise. For example, a football team does not want its opposing team to forecast its plays with 100 percent accuracy because it will field defenses specifically designed to stop the predicted plays. The team wants to mix up its plays and surprise the other team. This same logic can hold in business.
306 Part 2 Managerial Economics
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Figure 9.4 Coordination/ Competition Game
Boeing and Airbus must make simultaneous choices of new communication systems for their planes. Two technologies exist: Alpha and Beta (payoffs in millions of dollars). Both firms benefit if they choose the same technology. Applying the circle technique, we can see that there are two Nash equilibria (shaded cells): Alpha/Alpha and Beta/Beta. Boeing prefers the Alpha/Alpha equilibrium, whereas Airbus prefers the Beta/Beta equilibrium.
M A N A G E R I A L A P P L I C AT I O N S
Ice Cream Wars The Indian frozen dessert market of $200 million a year is expected to grow 20 percent annually as Indians’ inclination to
snack is increasing. Two companies compete for the majority of India’s ice cream market: Hindustan Lever, Ltd. (better
known as HLL) and Amul. Between them they sell about 75 percent of the ice cream in most major markets. HLL is
51 percent owned by the British-Dutch giant Unilever, and Amul is owned by an Indian farmers’ cooperative of 2 million
farmers. Amul sells a no frills ice cream under the slogan “A taste of India” and spends less than 1 percent of their
revenues on advertising; whereas HLL spends 10 to 15 percent. Amul sells its ice cream at about 12 percent less than
HLL. Being a full-line dairy concern, Amul markets related products, thereby reducing its distribution costs. HLL claims
they produce a higher quality product, but Amul counters that they have lower costs. HLL’s executive director complains,
“They rebuff attempts to form an ice cream trade body. How can we take them seriously?” But HLL is losing ground;
their ice cream revenue was down in the first quarter of 2002, and they lost 2 percentage points of market share.
It appears as if Amul has a dominant strategy built around being the low-cost producer. Not only is Amul capturing
market share from HLL, but also Amul has rejected HLL’s attempt at a coordination game in the form of an “ice cream
trade body.”
Source: S. Rai (2002), “Battling to Satisfy India’s Taste for Ice Cream,” New York Times (August 20), W1.
Chapter 9 Economics of Strategy: Game Theory 307
$10
−$10
B o
e in
g —
N e
g a
ti ve
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a ig
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−$10
Airbus— Negative campaign
B o
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Airbus— Positive campaign
Airbus— Positive campaign
B o
e in
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ti ve
c a
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Airbus— Negative campaign
B o
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P o
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Figure 9.5 Mixed Strategy
Boeing and Airbus simultaneously must commit to an advertising campaign. The advertising can focus on either the negatives of the other company’s planes or the positive aspects of the company’s own planes (payoffs in millions of dollars). Boeing is the market leader and benefits when both firms choose the same strategy. Airbus does better when it can differentiate itself by choosing a different strategy. The circle technique indicates that there is no equilibrium in pure strategies. There is a unique equilibrium in mixed strategies. In this equilibrium, each firm randomizes between the two campaigns (choosing each with a probability of .5).
Consider the strategic problem in Figure 9.5 where Boeing and Airbus simultane- ously must commit to an advertising campaign. The advertising might focus on either the negatives of the other company’s planes or the positive aspects of the com- pany’s own planes. Boeing is the market leader and benefits more when both firms choose the same strategy. Airbus does better when it can differentiate itself by choos- ing a different strategy. The circle technique indicates that there is no equilibrium in pure strategies. If the campaigns match, Airbus wants to change. If the campaigns do not match, Boeing wants to change.
The problem has an equilibrium employing mixed strategies: Both firms random- ize between the two actions with a probability of 0.5—they might base their actions on a coin flip. To understand why this is an equilibrium, consider the following logic.9 This problem is what is called a zero-sum game: If Boeing gains $10 (mil- lion), Airbus loses $10 and vice versa. Thus if one company has a positive expected value in the game, the other must have a negative expected value. If Boeing selects one of the campaigns with a probability greater than 0.5, Airbus can choose the other campaign with a probability of 1 and gain more than half the time. For instance, sup- pose Boeing chooses a positive campaign with a probability of .6, Airbus would gain 60 percent of the time by always choosing a negative campaign. Its expected payoff would be .6(10) � .4(�10) � 2 � 0. Boeing’s expected payoff would be .6(�10) � .4(10) � �2 � 0. The only way that Boeing can ensure an expected payoff of zero is by randomizing between the two actions with equal probabilities.10 Symmetric
9All strategic interactions with a finite number of both players and actions have at least one Nash equilibrium
in either pure or mixed strategies. In this chapter, we give examples of mixed strategies and discuss the
general intuition behind the associated equilibria. More detailed discussion on how to solve for these
equilibria can be found in Dixit and Nalebuff (1993), Chapter 7. 10If Boeing chooses each action with a probability of 0.5, the expected payoff is zero independent of Airbus’
strategy. Suppose Airbus chooses the positive campaign with probability p. The probability of Boeing matching the positive campaign is 0.5p (the probability of two independent events is the product of the individual probabilities of the events). Similarly the probability of matching a negative campaign is 0.5(1 � p). Thus the likelihood of Boeing winning is 0.5p � 0.5(1 � p) � 0.5. It correspondingly loses 0.5 of the time and has an expected payoff of zero. This is true independent of the p Airbus actually chooses.
308 Part 2 Managerial Economics
logic holds for Airbus. The outcome of both firms randomizing with a probability of 0.5 is a Nash equilibrium. Neither firm has an incentive to change its strategy given the strategy of the other firm.
In equilibrium, a firm receives the same expected payoff regardless of which of the campaigns it actually chooses. Thus if Boeing flips a coin that indicates it should choose a positive campaign, there is no reason to deviate and choose a negative cam- paign. In either case it gets the same expected payoff (zero). By definition, it would not be an equilibrium if either firm had an incentive to alter its choice.
Managerial Implications
Managers often make decisions in circumstances where the decision is not expected to be repeated and the payoff depends on the simultaneous decisions of other parties, be they rival firms, customers, suppliers, or employees. Potential examples include
M A N A G E R I A L A P P L I C AT I O N S
The Critical Importance of Considering Strategic Interactions—Borders Books Borders liquidated its business in 2011. At the time, it was the nation’s second largest bookstore chain. Nearly 11,000
employees lost their jobs when the company closed its hundreds of stores around the country.
Borders had been in business for 40 years, and along with Barnes and Noble had pioneered the large “brick-and-
mortar” bookstore. The book-selling industry, however, changed dramatically in subsequent years with the Internet and
the dramatic growth of Amazon.com and e-books.
Borders’ management appeared largely to ignore Amazon’s cost advantages in selling books online, as well as its
incentives to undercut Borders’ prices. Despite this competitive threat, Borders continued to invest in building and
refurbishing stores with large inventories of books, CDs, and DVDs. In contrast to Barnes and Noble, they did not
invest in developing online sales capacity. In the years leading up to its collapse, many shoppers visited Borders’ stores
to find or examine books, simply to purchase them from Amazon at a lower price.
The failure of Borders’ management sufficiently to consider Amazon’s competitive responses (as well as their
typical customer’s price sensitivity) contributed to their ultimate collapse. Managers generally will make better
decisions if they incorporate the incentives and responses of competitors into their analysis.
Source: Y. Noguchi (2011), “Why Borders Failed While Barnes and Noble Survived,” npr.org (July 19).
A Mixed Strategy at Wimbledon Tennis players can serve to either an opponent’s backhand or forehand. The receiver can choose to move left or right in
anticipation of the serve. Both the opponent and receiver want to mix their choices to catch the other off guard. For
example, if the server always serves to the backhand, the receiver will know that it is best to favor that side. The server
would then want to mix it up and serve to the opponent’s forehand. In a mixed-strategy equilibrium, the expected
payoff to a given player is the same regardless of which action he actually ends up taking. Thus, if the server is mixing
between serving to the receiver’s backhand and forehand, the likelihood of winning the point should be the same. To
test whether the concept of a mixed-strategy equilibrium actually explains the behavior of top tennis players,
researchers recorded the results of serves in 10 matches at Wimbledon. There, data supported the theory—the success
rates with serves to either the forehand or backhand were the same.
Source: M. Walker and J. Wooders (2001), “Minimax Play at Wimbledon,” American Economic Review 91, 1521–1538.
A C A D E M I C A P P L I C AT I O N S
making a large investment decision to enter a new market or industry, pricing a new product, or making an acquisition bid for a firm.
To summarize the managerial implications of our analysis, consider Valerie Black, who must submit the bid for Boeing in our example. Val should perform the following calculations:
• Estimate the payoffs given each of her potential actions as well as those of her rival, Airbus.11
• Examine whether she has a dominant strategy—if so, she should employ it.
• Without a dominant strategy, she should make her best estimate of what Airbus will do and identify her corresponding best action (which might be a mixed strategy).
• Check whether the resulting outcome is a potential Nash equilibrium: Does the forecasted action of Airbus appear optimal from their viewpoint, given her proposed action? If so, her proposed action appears reasonable; if not, Val should reexamine the underlying assumptions of her initial forecast.
Her forecast probably should be revised if it is based on the implicit assumption that Airbus is either dumb or irrational (e.g., Airbus is unable to forecast a likely action on her part or does not know what is in its own best interests). In essence, Val should place herself behind her rival’s desk and ask what she would do if she worked for Airbus. She should assume that Airbus undoubtedly is trying to forecast her actions, as well. Is there some reasonable set of beliefs that Airbus might have about her actions that would motivate the firm to choose the action in the initial forecast—can it be rational- ized? If not, Val probably should revise the forecast. Since Val almost surely has less than perfect information about the factors affecting Airbus’ choice, she may misfore- cast what Airbus actually does. Nonetheless, her goal is simply to do the best she can, given her imperfect information. Sometimes it will pay to collect additional informa- tion about a rival to make a better-informed choice (when the expected incremental benefits of the new information are larger than its incremental costs).
If Val is reasonably confident that Airbus will choose what appears to be a non- equilibrium strategy (e.g., Airbus has a track record of choosing a particular strategy in similar situations), she should reevaluate both her and her rival’s available actions and their associated payoffs carefully. It is frequently the case that what appears to be a nonequilibrium move reflects an incomplete understanding of the alternatives. Ultimately, if she is quite confident that Airbus will choose a particular action, she should choose the action that maximizes her payoff, even if the outcome is not a Nash equilibrium.
If Val is extremely risk-averse and has little experience either dealing with this rival or managing in similar situations, one option is to choose a secure strategy—a strategy that guarantees the highest payoff given the worst possible case.12 In other words, she forecasts the worst payoff that could arise for each of her potential actions and chooses the action that offers the highest payoff among the worst payoffs. But fol- lowing such a strategy generally will not maximize the value of the firm (e.g., if the primary benefit is to guard against an unlikely outcome), and often she could do better with additional analysis and thought.
Chapter 9 Economics of Strategy: Game Theory 309
11If she has many potential actions, she may wish to simplify the problem by focusing on a few key
possibilities. Sometimes it is not feasible to quantify the payoffs. In these cases, managers can go through
the following steps on a more qualitative basis. 12Another name for this type of strategy is maximin.
310 Part 2 Managerial Economics
Sequential Interactions Thus far, we have limited our attention to simultaneous-move strategic problems. Yet in many business situations, managers make decisions sequentially. For example, consider the problem in Figure 9.4 where Boeing and Airbus simultaneously chose new communication technologies. Decisions of this type often are made sequen- tially. For example, Boeing might choose the technology in one year, while Airbus chooses it in the next. As we shall see, the equilibrium outcome of strategic interac- tions can vary, depending on whether they occur simultaneously or sequentially. For instance, in this technology choice problem, there are two possible equilibria given simultaneous choices, but only one given sequential choices.
Extensive Form Figure 9.6 displays this strategic interaction in extensive form assuming that Boeing moves first (e.g., Boeing chooses the technology for the new model it introduces at this year’s Paris Air Show, while Airbus will introduce its new model next year). The extensive form depicts the sequence of actions and the corresponding outcomes. A node indicates a point at which a firm must choose an action, while the branches lead- ing from a node display possible choices at the node. At the first node (node 1) Boe- ing must choose between the Alpha and Beta technologies. Airbus makes the next move. Whether it is at node 2 or node 3 depends on Boeing’s initial choice. At either node Airbus must choose whether to adopt the Alpha or Beta technology. The numbers at the end of the final branches indicate the ultimate payoffs to Boeing and Airbus, given the sequence of choices made by the two firms. (These payoffs are the same as in Figure 9.4.) If both firms choose the Alpha technology, the payoffs are 100
Figure 9.6 Extensive Form
In this sequential game, Boeing chooses the technology first and then Airbus makes a choice. This diagram shows the game in extensive form. A node indicates a point at which a firm must choose an action, whereas the branches leading from a node indicate the possible choices. The numbers at the end indicate the payoffs (in millions of dollars) for Boeing and Airbus, respectively. The game is solved by backward induction. Given the payoffs, Airbus will choose Alpha at node 2 and Beta at node 3. If Boeing forecasts these choices, it will choose Alpha at node 1. Bold lines indicate equilibrium choices.
Boeing
Airbus
Airbus
Boeing 100 Airbus 50
Boeing 40 Airbus 40
Beta
Beta
Alp ha
Beta
Alp ha
Alp ha
Node 1
Node 2
Node 3
Equilibrium
Boeing 25 Airbus 25
Boeing 50 Airbus 100
Chapter 9 Economics of Strategy: Game Theory 311
for Boeing and 50 for Airbus (as in the upper-left cell of Figure 9.4), while if they choose the Beta technology, the payoffs are reversed (as in the lower-right cell). Pay- offs are lower for both firms when they choose different technologies.
Backward Induction We analyze this extensive form using backward induction—looking forward to the final outcomes (decision nodes) and reasoning backward. To illustrate, continue with the example in Figure 9.6. Begin at the final two nodes (2 and 3). At node 2, Airbus has an incentive to choose Alpha because it prefers the payoff of 50 to 40. At node 3, Airbus chooses Beta. Now move to the initial node. If Boeing foresees how Airbus will act at the final nodes, Boeing will see that it is in its best interests to choose Alpha in the initial stage. If it chooses Alpha, Airbus will do so as well and Boeing will receive 100. By contrast if Boeing chooses Beta, Airbus will match that
ANALYZING MANAGERIAL DECISIONS: Let’s Make a Deal
You work for a company that is frequently involved
in negotiations to acquire companies from their
current owners. You have been invited to be a guest
on the popular television game show Let’s Make a Deal. Your boss has agreed that you can participate on the game show during business hours because
you might learn something that would be valuable in
future business negotiations.
You are now on the game show. The following
events have occurred to this point:
• The game show host showed you three doors,
labeled Door #1, Door #2, and Door #3 and
told you that behind one of the doors is the
grand prize of $100,000. The other two doors
contain smaller prizes of no more than
$20,000. You assume that the host knows
which door has the $100,000.
• You were told to choose one of the doors, and
you randomly chose Door #1.
• The host subsequently opened Door #2 and
showed you that it contains a smaller prize of
$20,000.
• He has given you the following choice. You
can keep what is behind Door #1 (your initial
choice). You can trade it for the $20,000 be-
hind Door #2, or you can trade it for the un-
known contents behind Door #3.
• You want to go for the grand prize of
$100,000. Thus you must decide whether to
keep Door #1 or trade it for Door #3.
1. You initially selected Door #1. Prior to seeing
the contents behind Door #2, what was the
probability that Door #1 contained the grand
prize? What was the probability that Door #1
did not contain the grand prize (i.e., the
grand prize was behind one of the other
two doors)?
2. The host subsequently showed you that
Door #2 contained $20,000 and gave
you the choice to keep what was behind
Door #1 or to trade it for what was behind
Door #3. What should you do or does it
matter (assuming you want to go for the
grand prize)? [Hint: “Put yourself behind the host’s podium” and consider his choice to
show you the contents behind one of the
doors. It might be useful to view the situation
as a sequential game where you choose the
first door at Node 1 and the host subse-
quently chooses which of the remaining
doors to show you at Node 2.]
3. Your boss let you participate in the game
show because she thought you might learn
something that would be of value to your
company. Does your experience on the game
show suggest any general principles that
might be useful in managerial situations?
Explain.
312 Part 2 Managerial Economics
choice and Boeing will receive a final payoff of 50. Thus, the equilibrium outcome is for Boeing to choose Alpha in the first stage with Airbus matching that choice in the second stage.
The equilibrium strategy of a firm given sequential strategic interaction consists of a sequence of its best actions, where the actions are taken at the corresponding nodes. In this problem, Boeing’s equilibrium strategy is to choose Alpha in the first stage, whereas Airbus’s equilibrium strategy is to choose Alpha in the second stage if Boeing chooses Alpha and Beta if Boeing chooses Beta. The strategies of the two firms are a Nash equi- librium: Neither firm wants to change its strategy given the other firm’s strategy.
First-Mover Advantage
In this example, Boeing has a first-mover advantage: By moving first, Boeing makes higher profits than Airbus, who moves second. If Airbus moves first, the ad- vantage is reversed. Knowing Boeing’s incentive to match the technology in the second stage, Airbus would choose Beta in the first round and receive higher prof- its. This example illustrates that managers must consider carefully the order of moves in strategic situations. When Boeing and Airbus make simultaneous choices, there are two potential equilibria. In the sequential game there is only one. The out- come, however, depends on who moves first.
The first mover does not always have a strategic advantage. In some situations, the follower has the advantage. Consider a firm that cuts its development costs by copying product innovations by pioneering firms—after all, the second mouse gets the cheese.
Strategic Moves
Actions that are taken to influence the beliefs or actions of the rival in favorable ways are called strategic moves. Typically, they require individuals to restrict their own fu- ture actions. For example, prior to Boeing’s choice, if Airbus could make a binding commitment to choose Beta no matter what Boeing did, it then would be in Boeing’s interest to adopt the Beta technology in the first year.
Credibility Can Airbus offset Boeing’s first-mover advantage by simply announcing that it will adopt the Beta technology next year no matter what Boeing does this year? Boeing would be clearly better off to adopt the Beta technology if it really be- lieved that Airbus would carry out its announced plan. Yet Boeing probably should ignore such a statement by Airbus unless it is credible. The statement would lack credibility if it would not be in Airbus’ self-interest to carry out its announced plan were Boeing adopted the Alpha technology first. In that case,
M A N A G E R I A L A P P L I C AT I O N S
First-Mover Advantage—Walmart In Chapter 8, we discussed how Walmart was the first company to place large discount stores in many small towns in
the southeastern region of the United States (for instance, in Arkansas). Even though Walmart has been quite profitable
at these stores, other companies have been reluctant to place competing stores in the same towns. They realize that
each town is big enough to support only one such store. If they did enter, they would have to compete with Walmart
and both would lose money. Thus Walmart has a first-mover advantage in these communities.
Chapter 9 Economics of Strategy: Game Theory 313
Airbus would be foolish to adopt the Beta technology after Boeing chooses the Alpha technology given its low payoff.
For a strategic move to be credible, it must consist of a sufficient commitment to convince the rival to change its beliefs. Merely announcing a planned future action typically is not enough—talk is cheap. As an example of a potentially credible action, suppose that Airbus signs a contract with the manufacturer of the Beta technology to pay the supplier a large sum of money whether or not Airbus employs its technology in the following year. This contract is legally binding and expensive to renegotiate. Now Boeing has a substantive reason to believe that Airbus will carry through with its announced plan to adopt the Beta technology even if Boeing were to choose the Alpha system. If it does not, it still will have to pay a large sum of money to the supplier and thus would be worse off than if it were to match Boeing by choosing the Alpha tech- nology. If Boeing decides this announcement is credible, Boeing should adopt the Beta system in the first year.13
Managerial Implications
Many strategic situations involve a sequence of actions by the rivals. Examples in- clude management negotiations with a labor union and the dissemination of a new product within an industry.
To illustrate the management implications of our analysis of sequential strategic in- teractions, consider Helmut Mueller, the manager who must choose the communication technology for Airbus in the communication technology problem discussed earlier. Helmut should begin by defining carefully the sequence of moves. For example, he may have enough information to know that Boeing will choose a new technology this year, whereas Airbus’ production schedule will not allow it to make a choice until the fol- lowing year. He then should work backward to predict the likely outcome of their inter- action. Starting at the end of the process, he will realize that he will have a strong incentive to match Boeing’s choice in the second period. Moving to the first node, he should place himself behind a Boeing desk. He should realize that Boeing is likely to understand that Helmut will have strong incentives to match Boeing’s technology in the second period. Given this belief, Boeing will adopt the Alpha technology. Airbus is less profitable with this outcome and thus would prefer the joint adoption of the Beta system. As a final step, he should analyze whether he could make any strategic moves that would influence the beliefs of Boeing managers and thus motivate them to adopt the Beta technology. He must realize that Boeing’s management is unlikely to believe a simple announcement that Airbus will choose the Beta technology in the future. Helmut might conclude that a contract with the Beta manufacturer would provide sufficient commitment to alter Boeing’s beliefs and choice. After entering this contract, it is im- portant that Helmut make his action known to Boeing. For instance, Helmut might want to report the contract to the financial press.
13Note to the technically inclined: If Boeing actually believed Airbus’s statement that it would choose Beta in
the second round regardless of Boeing’s first round choice, Boeing would logically choose Beta in the first
round. The outcome Beta/Beta is a second potential Nash equilibrium to this game—neither party has an incentive to alter its choice of Beta given the other firm’s action. However, this second potential equilibrium
can be ruled out if we require that both parties expect each other to act rationally (in their own interest) at
any node in the game (on or off the equilibrium path). Game theorists refer to this criterion for eliminating
unlikely equilibria as “subgame perfection.” We think this “selection criterion” is quite reasonable and
should be employed by managers in their analysis of strategic situations. Using this criterion, there is only
one economically reasonable equilibrium to this game, Alpha/Alpha (unless, as we discuss next, Airbus can
make an economically credible commitment always to choose Beta in the second round).
314 Part 2 Managerial Economics
Repeated Strategic Interaction Many strategic situations involve repeated interaction among rivals. For example, Boeing and Airbus have many opportunities to compete against each other to supply commercial jet aircraft. Indeed many, if not most, companies deal with the same competitors, suppliers, employees, and regulators over extended periods of time.
When interaction is expected to occur repeatedly, more equilibria frequently are possible. For instance, recall the situation illustrated in Figure 9.1. In this problem, Boeing and Airbus make bids to produce 10 airplanes. The dominant strategy is for
M A N A G E R I A L A P P L I C AT I O N S
Strategic Behavior—NHL Negotiations between management and labor unions can be viewed as a game. Both sides engage in strategic behavior,
hoping to win more for their sides. Sometimes these strategic interactions result in labor strikes and lockouts that end
up being costly to both parties.
Consider the labor dispute in the National Hockey League (NHL) during the 2012–2013 season. The failure of
owners and the players to agree to a new contract before the old one expired resulted in a player lockout that lasted
from September 15, 2012 to January 12, 2013. The regular season was reduced from 82 to 48 games and the annual All
Star Game was cancelled.
As the September 2012 deadline approached, the owners and players exchanged a series of proposals and counter
proposals. The union’s last offer, prior to the deadline, continued to insist on a salary cap that was not linked to revenue
and that would steadily increase over a five-year term. Owners refused to budge from their initial position of wanting to
reduce the players’ share of hockey-related revenues from 57 percent under the old contract to 46 percent. Both sides
adopted “hard nose strategies” hoping the other side would cave into their demands prior to the deadline. They did not.
During the lockout, both sides presented a series of threats and counter threats. For example, various notable players,
who had signed to play for European teams during the lockout, threatened not to return when the lockout ended. These
threats, however, were not very credible and almost all players quickly returned to the NHL once the dispute was settled.
There is disagreement over which side came out better. The owners got a 50-50 split of revenues (a 7 percent
reduction for the players from the previous contract), while the players got the better deal on the length of contracts,
salary caps, and pension plan. What is clear is that the dispute was very costly to both sides. The NHL Commissioner
estimated that the owners had combined losses of between $18 and $20 million per day during the lockout, while the
players lost between $8 and $10 million in salaries. The dispute lasted 119 days.
Source: Tribune Company writers (2013), “Who Emerged As the Winner after the NHL Labor Dispute?”, Los Angeles Times Website
(January 7).
M A N A G E R I A L A P P L I C AT I O N S
It Pays to Think Sequentially According to a story that frequently has circulated over the Internet, two college students drove to an out-of-town
basketball game the day before an important exam. The students drank too much and were unprepared to take the test.
Rather than flunk the exam, they decided to tell the teacher that a flat tire delayed their return. Being the understanding
type, the professor said, “No problem; take the test tomorrow.” The students arrived the next day to take the exam; they
were put into separate rooms. The first question, worth 5 points, was quite easy. But confidence turned to apprehension
as each student turned to the next question, worth 95 points, that simply asked, “Which tire?” If the students had
thought ahead more carefully, they would have behaved differently.
Chapter 9 Economics of Strategy: Game Theory 315
both to bid low, even though they would be better off if both bid high—a rivals’ dilemma. With repeated interaction, the equilibrium still might consist of both firms’ pricing low. However, other equilibria, such as both firms’ pricing high, are possible. The basic idea is that with repeated interaction, there is more to consider than the short-run payoffs. The decision maker also has to consider the potential benefits of es- tablishing a long-term cooperative relationship.
The appendix to this chapter contains an example of how rivals’ dilemmas (such as in the Boeing/Airbus problem) sometimes can be overcome given repeated inter- action.14 The likelihood of a “cooperative” outcome increases if (1) the long-run gains from cooperating are larger relative to the short-run gains from not cooperating (assuming the other firm does), (2) it is easier for the firms to recognize whether or not cooperation has occurred, and (3) the expected length of the repeated relationship is longer. Discount rates also are important (higher discount rates imply that the decision maker cares more about present payoffs relative to future payoffs). The appendix em- phasizes the managerial implications of this analysis. In Chapter 21, we revisit this topic by discussing how reputational concerns can motivate managers to behave with integrity in economic transactions.
While certain conditions increase the likelihood of cooperative outcomes in repeated settings, noncooperative outcomes can almost always still occur. Indeed, the so-called Folk Theorem tells us that there is generally a large set of potential Nash equilibria in repeated games.15
M A N A G E R I A L A P P L I C AT I O N S
Price Fixing in the Auto-Parts Industry A U.S. grand jury indicted three former executives of the Bridgestone Corporation in April 2014 for allegedly
conspiring to fix automotive-part prices. The indictments were part of an ongoing investigation by the U.S. Department
of Justice that had previously netted $2.29 billion in fines and 26 guilty pleas from automotive-part companies. The
companies had admitted to taking part in explicit agreements among competitors to fix prices and rig bids in selling
parts to automobile manufacturers.
Game theory implies that a cooperative equilibrium is possible given repeated interaction without explicit
communication or collusion. One interpretation of joint price increases in an industry (above cost) is that the firms have
moved from cutthroat competition where each firms was losing money to a more cooperative equilibrium. Experience
suggests, however, that cooperative equilibria are not always easy to sustain. Consider the difficulties experienced by
OPEC in trying to restrict output to maintain high oil prices or the American airline industry in avoiding price wars.
Source: L. Vellequette and P. Nussel (2014), “Bridgestone executives indicted for auto parts price fixing,” Automotive News (April 16).
14Generally, it is important to have an uncertain ending date in the repeated relationship. If there is a finite ending
date, both you and your rival are likely to realize that there is no incentive for either of you to cooperate in the
last interaction. Then both of you will have an incentive not to cooperate in the next to the last interaction (since
your reputation for cooperating will not matter in the last round). Yet if this is true, there is no incentive to
cooperate in the interactions before. The final result can be no cooperation in the first interaction. If on the other
hand the date of the final interaction is uncertain, there always can be some reason to cooperate. 15“Evolutionary Game Theory” argues that strategies with relatively efficient payoffs are more likely to
“reproduce and survive” in a competitive environments. As in biological Darwinism, there is a tendency
toward “survival of the fittest.” The evolutionary approach has the potential to reduce the large number of
possible equilibria in repeated games to a much smaller set of most plausible equilibria. See H. Gintis
(2009), Game Theory Evolving: A Problem-Centered Introduction to Modeling Strategic Interaction, second edition (Princeton University Press: Princeton, NJ).
316 Part 2 Managerial Economics
Strategic Interaction and Organizational Architecture We have focused on competition between rival firms throughout this chapter, but the analysis of strategic interactions has much broader implications and can provide use- ful implications for managers when interacting with other parties within their own or- ganization. Part 3 of this book examines organizational architecture. As an introduc- tory example, consider the problem in Figure 9.7 between a manager, Kiana Ross, and a lower-level employee, Lenin Steenkamp. Len must decide whether to work or shirk. If he exerts effort, the value of his expected output is $25 (all numbers in this example are in thousands of dollars); if he shirks, the expected output is $5. Len does not like exerting effort and bears personal costs if he works that he values at $5, but no cost if he shirks. Kiana can monitor Len for a cost of $5 and can tell whether or not he has exerted effort.16 The labor contract pays the employee $10, unless he is caught shirking—in which case, he is fired and receives no payment.
16Kiana cannot tell for sure if Len has worked from simply observing his output. Although the expected output
is $25 or $5, depending on whether or not Len works, output is also affected by random factors beyond Len’s
control. Thus output can sometimes be high even if Len has not worked, and low even if he has.
−$5
$15
Len—Shirks
Len—Shirks
Len—Works
Len—Works K
ia n
a —
N o
t m
o n
it o
r
$15
$10
$5
$0
K ia
n a
— M
o n
it o
r
$10
$10
K ia
n a
— M
o n
it o
r K
ia n
a —
N o
t m
o n
it o
rFigure 9.7 Incentive Game
The employee, Len Steenkamp, decides to work or shirk, and the manager, Kiana Ross, decides whether or not to monitor (payoffs in thousands of dollars). Len would prefer to shirk than to work, whereas it is costly for the manager to monitor. As the circle technique shows, there is no pure-strategy equilibrium. If the employee works, the manager does not want to monitor; if the manager does not monitor, the employee shirks. There is a mixed-strategy equilibrium where Len randomizes between working and shirking and Kiana randomizes between monitoring and not monitoring (all with a probability of .5).
M A N A G E R I A L A P P L I C AT I O N S
Auditing—A Mixed-Strategy Equilibrium Independent accountants commonly audit firms. One of the reasons audits exist is to help ensure that managers are not
embezzling funds. Accountants do not verify all economic transactions when they audit a firm. Rather, they review
most of the large transactions and draw a random sample of the smaller ones. If accountants reviewed every
transaction, there would be little or no fraud (since managers would know they would get caught if they were
fraudulent). However, given the correspondingly small chance of fraud, it would not make economic sense to bear the
high costs of auditing every transaction. The result is a mixed-strategy equilibrium. Auditors randomly select accounts
to audit and managers sometimes engage in fraud. In practice, auditors also audit accounts more intensely when
available information (e.g., a suspicious account entry) increases the likelihood that fraud has occurred.
Chapter 9 Economics of Strategy: Game Theory 317
ANALYZING MANAGERIAL DECISIONS: Holland Sweetener versus Monsanto
Aspartame is a low-calorie sweetener marketed by
Monsanto under the name of NutraSweet. It was a
major impetus to the rapid growth of Diet Coke and
Diet Pepsi during the 1980s and 1990s. A scientist at
the G. D. Searle & Co. first discovered aspartame in
1965; Searle received a patent for the product in
1970. U.S. regulators did not approve its use in soft
drinks until 1983. In 1985, Monsanto acquired
Searle—and with it a monopoly on aspartame.
Monsanto’s patents expired in 1987 and 1992 in
Europe and the United States, respectively.
In 1986, Holland Sweetener was formed through
a joint venture of Tosoh Corporation and Dutch
State Mines. Its sole purpose was to challenge
Monsanto in the aspartame market. It began by
building a plant in the Netherlands to compete in
the European market. The “big prize,” however,
was the U.S. soft-drink market, which was to open
up at the end of 1992.
Initially, Holland Sweetener was quite optimistic
about capturing a large share of the U.S. market. To
quote their vice president of marketing and sales in
referring to Coke and Pepsi, “Every manufacturer
likes to have at least two sources of supply.” To
Holland Sweetener’s surprise, they never became a
big player in the U.S. market. In 1992, just before
Monsanto’s patent expired, Coke and Pepsi signed
long-term contracts with Monsanto for the continued
supply of NutraSweet. The big winners in this con-
tract negotiation were Coke and Pepsi, who realized
about $200 million a year in savings. Monsanto re-
mained the major supplier to these companies, while
Holland Sweetener was “left pretty much out in the
cold.” In 2006, Holland Sweetener announced it was
exiting the aspartame business.
Envision a pricing problem between Monsanto
and Holland Sweetener in 1992 that led to the
Monsanto contract. Assume (1) the cost to Holland
Sweetener of entering the U.S. market, $25 million,
has been incurred; (2) Monsanto and Holland Sweet-
ener simultaneously choose to quote either a high or
low price to Pepsi and Coke for aspartame; (3) if both
Monsanto and Holland Sweetener quote the same
price, Pepsi and Coke contract with Monsanto be-
cause customers are familiar with the NutraSweet
label—Holland Sweetener loses its initial investment;
(4) if both firms submit a high price, Monsanto nets
$300 million; (5) if both firms submit a low price,
Monsanto nets $100 million; (6) if Monsanto prices
high and Holland Sweetener prices low, Holland
Sweetener nets $100 million (after the initial
investment) and Monsanto nets $0.
1. Construct the strategic-form payoff matrix for
this strategic pricing problem. Find the Nash
equilibrium.
2. Now assume that the interaction is sequential
where Holland Sweetener chooses to enter and
if so they face the pricing problem in the sec-
ond stage. Should Holland Sweetener enter?
3. Why do you think Holland Sweetener entered?
Were they just dumb or were there other poten-
tial considerations?
4. Prior to Holland Sweetener’s entry into the
U.S. market, Pepsi and Coke began deempha-
sizing the NutraSweet label on their cans and
bottles. Why do you think they did this?
5. Explain how Monsanto had a “first-mover’s
advantage.”
6. Pepsi and Coke were the big winners in this
case. Explain why.
Sources: A. Brandenburger and B. Nalebuff (1996), Co-opetition (Doubleday: Garden City; and DSM, Corporate Communications (2006), “DSM Press Release: Holland Sweetener Company to Exit from Aspartame Business,” (March 30).
The circle technique indicates that there is no pure-strategy equilibrium. The reason is that if Len always works, Kiana has no incentive to monitor, whereas if Kiana were never to monitor, Len always would shirk. This problem has an equilib- rium in mixed strategies, where Len works some of the time and shirks others, and Kiana monitors some of the time and not others.17
17In this equilibrium, both Kiana and Len randomize between their two actions, choosing each action .5 of the
time.
318 Part 2 Managerial Economics
Figure 9.7 indicates that the combined payoff is highest when Len always works and Kiana never monitors. Although this outcome is not a feasible equilibrium if the interaction is not repeated,18 Kiana might be able to promote this equilibrium within an actual firm. For instance, one tool that Kiana has at her disposal is the structure of the labor contract. It might be possible to motivate Len to work in the absence of monitoring by paying him a share of total output, thus offering incentive compensa- tion rather than a fixed salary. Altering the labor contract creates a new set of payoffs and potentially a more preferred equilibrium. Chapters 11–17 analyze, in detail, how managers can use compensation plans and other organizational arrangements to in- crease productivity and the firm’s value.
This example is but one of many ways that managers might apply these methods to analyze business problems. The chapter appendix provides another example.
Summary Game theory is concerned with the general analysis of strategic interaction. It focuses on optimal decision making when all decision makers are presumed to be ra- tional, with each attempting to anticipate the likely actions and reactions of its rivals. These techniques can be employed to study a wide variety of phenomena ranging from parlor games to politics and competitive strategy. In this chapter, we introduce the basic elements of this theory in the context of managerial decision making.
In simultaneous-move problems, firms must make decisions without knowledge of the decisions made by their rivals. Nonrepeated means that the game is played only once. We diagram these interactions by showing the payoffs in strategic (nor- mal) form.
A dominant strategy exists when it is optimal for the firm to choose a particular strategy no matter what its rival does. A firm should employ a dominant strategy if one exists.
Firms do not always have dominant strategies. When dominant strategies do not exist, we employ the concept of a Nash equilibrium to predict the outcome of the interaction. A Nash equilibrium is a set of strategies (or actions) in which each firm is doing the best it can, given the actions of its rival. A problem can have multiple Nash equilibria. Nash equilibria are not necessarily the outcomes that maximize the joint payoff of the firms. The circle technique provides a simple method to identify Nash equilibria.
The power of a Nash equilibrium to predict the outcomes of strategic interactions stems from the fact that Nash equilibria are self-enforcing—they are stable outcomes. In many cases it is reasonable to expect that a Nash equilibrium will occur. This is par- ticularly true when the firms have experience with similar problems, when they have information about each other, or when the Nash equilibrium outcome is a natural “focal point.”
Some interactions are competitive—at least one of the firms has an incentive to take actions that benefit them at the expense of their rival. Other strategic situations involve coordination rather than competition. Some interactions have elements of both.
When a firm chooses one specific strategy or action, it is called a pure strategy. Sometimes it can pay to randomize—to use a mixed strategy. The benefit of a mixed strategy comes from the element of surprise; sometimes a firm is at a disadvantage if it is too predictable.
18It is achieved one-quarter of the time in the mixed-strategy equilibrium (.5 � .5).
In many business situations, managers make decisions sequentially. Sequential in- teractions are pictured in extensive form. The extensive form displays the sequence of actions and corresponding outcomes. A node indicates a point at which a party must choose an action, and the branches leading from a node display the possible choices at the node. We solve the extensive form by backward induction—looking forward to the final decision nodes and reasoning backward.
In some interactions it is advantageous to move first: There is a first-mover ad- vantage. In other cases it is better to move second.
Strategic moves are taken to influence the beliefs or actions of the rival in favorable ways. Typically, strategic moves involve a firm restricting its own future actions. For strategic moves to work, they must be credible. For a strategic move to be credible, it must include a commitment sufficient to convince its rival to change its beliefs.
Many strategic situations involve repeated interaction among rivals. When an interaction is expected to occur more than once, it is called a repeated interaction. Typically, more equilibria are possible with repeated interaction than in a nonrepeated problem. For instance, cooperation is a potential equilibrium in repeated rivals’ dilemmas (see the appendix to this chapter for a more detailed analysis).
This chapter focuses primarily on competition between rival firms. The analysis of strategic interactions also provides managerial insights for interactions with other parties, such as suppliers and government regulators. It can be particularly useful in analyzing interactions with other employees within the firm.
Chapter 9 Economics of Strategy: Game Theory 319
M A N A G E R I A L A P P L I C AT I O N S
Key Managerial Insights from Game Theory Most business problems are more complex than the simple examples used in this chapter. Although technical
challenges mount as the number of rivals and the range of potential actions increase, some of the basic insights from
elementary game theory are quite robust. Some of the key insights are as follows:
• Understand your business setting. Identify the relevant set of rivals and the nature of their interaction. What are the potential actions? What information will they have when they choose their actions? What are the
consequences of their various actions? Is similar interaction among these rivals likely to be repeated over time or
across other markets?
• Place yourself behind your rival’s desk. Consider the entire sequence of decisions that are likely to be made over the course of this interaction. Look forward to the ultimate set of potential outcomes and then reason
backward to determine your best strategy. This process identifies critical choices that your rivals face and
highlights why you should understand the basis for their choices.
• With a first-mover advantage, move first. If the business setting does not naturally permit you to implement your action first, consider whether you can credibly precommit to a particular action. Effective precommitment, by
convincing your rivals of your future actions, can induce them to change their actions. This logic highlights the
fact that maintaining flexibility undercuts your ability to precommit—in this sense, flexibility can be quite
expensive.
• With a second-move advantage, avoid moving first. Delay implementation of actions where possible. Try to reduce the predictability of your actions. Finally, if you have to implement an action, maintain as much future
flexibility to change your actions as possible.
• Repetition facilitates cooperation. Some productive form of cooperation is more likely when interaction is expected to be repeated either over time or across markets.
320 Part 2 Managerial Economics
A. Dixit and B. Nalebuff (1993), Thinking Strategically (W.W. Norton & Company: New York).
J. McMillan (1996), Games, Strategies, & Managers (Oxford University Press: New York).
9–1. Time Magazine and Newsweek are two competing news magazines. Suppose that each company charges the same $5 price for their magazines. Each wants to maximize its sales
given the $5 price. Each week, there are two potential cover stories. One is on politics. The
other is on the economy. Sales of both companies are affected by the decisions on which
story to place on their covers. The two magazines make this decision independently and at
the same time. The resulting sales for the two companies are given in the following table:
Time Sales Newsweek Sales Time Cover Newsweek Cover ($000’s) ($000’s)
Politics Politics 400 150 Politics Economy 700 200 Economy Economy 200 150 Economy Politics 300 700
a. Construct a diagram that shows the payoffs to the two firms in strategic (normal) form. b. What is the Nash equilibrium in this game? c. Does either or both of the magazines have a dominant strategy in this game? d. Suppose that both magazines are owned by the same publishing company that maxi-
mizes the combined profits of the magazines. Will the company make the same choice
as in the noncooperative game?
9–2. a. Suppose that Newsweek chooses and announces its cover story before Time Magazine chooses its cover. Construct a diagram that shows the payoffs of the game in extensive form.
b. What is the Nash equilibrium in this game? c. Is there a first-mover advantage or first-mover disadvantage in this game?
Solutions to Self-Evaluation Problems 9–1. Simultaneous Moves, Nonreported Interaction
a. Below is the strategic form of the game where the two magazines make simultaneous moves (note that the circles and shaded quadrant are for Part b of this problem).
$400
$150
T im
e —
P o lit
ic s
T im
e —
E co
n o m
y
T im
e —
E co
n o m
y T
im e
— P
o lit
ic s
Newsweek—Politics
Newsweek—Politics Newsweek—Economy
Newsweek—Economy
$300
$700
$700
$200
$200
$150
Self-Evaluation Problems
Suggested Readings
Chapter 9 Economics of Strategy: Game Theory 321
b. The Nash equilibrium can be found by the circle technique. When Newsweek chooses Politics (first column), Time does best by choosing Politics—circle the $400 payoff. When Newsweek chooses Economy (second column), Time does best by choosing Poli- tics—circle the $700 payoff. When Time chooses Politics (first row), Newsweek does best by choosing Economy—circle the $200 payoff. When Time chooses Economy (second row), Newsweek does best by choosing Politics—circle the $700 payoff. The Nash equilibrium is for Time to choose Politics and Newsweek to choose Economy where both payoffs are circled. This is the shaded quadrant in the diagram.
c. Time has a dominant strategy in this game. It wants to choose Politics no matter what Newsweek does. Newsweek does not have a dominant strategy. Its optimal choice be- tween Politics and Economy depends on what Time chooses to do.
d. The publishing company would place Economy on Time’s cover and Politics on Newsweek’s cover. The combined profits are $1,000 versus $900 in the noncooperative game.
9–2. Sequential Interaction
a. Below is the extensive form of the game, where Newsweek moves first.
b. The Nash equilibrium (in bold and underlined in the figure) is for Newsweek to choose Economy and Time to choose Politics. This equilibrium is found as follows. Newsweek looks forward to Time’s choice and reasons backward. If Newsweek chooses Politics, Time will choose Politics and Newsweek will obtain 150 subscriptions. If it chooses Economy, Time will choose Politics and Newsweek obtains 200 subscriptions. Therefore it is in Newsweek’s interest to choose Economy. Time will subsequently choose Politics.
c. There is no first-mover or second-mover advantage in this game. Time has a dominant strategy always to choose Politics. Given this choice, Newsweek wants to choose Econ- omy. Therefore the equilibriums in the simultaneous and sequential games are the same.
9–1. Some manufacturers that contract with the U.S. government have most favored nation clauses in their contracts. This provision makes the firm sell to the government at the lowest price it charges to any other customer. On the surface this provision seems to be advanta-
geous to the government because it ensures them the lowest price charged to any customer.
Others argue, however, that the clause gives manufacturers more power in bargaining with
other buyers. Explain how this increased bargaining power might occur.
9–2. Suppose Microsoft can produce a new sophisticated software product. However, it wants to do so only if Intel produces high-speed microprocessors. Otherwise, the software will not
sell. Intel, in turn, wants to produce high-speed microprocessors only if there is popular
software on the market that requires high-speed processing. Is this a game of competition or
coordination? What is the equilibrium?
Review Questions
Newsweek
Newsweek 150 Time 400
Newsweek 700 Time 300
Newsweek 200 Time 700
Newsweek 150 Time 200
Economy
Economy
Economy
Po litic
s
Po litic
s
Po litic
s
Time
Time
322 Part 2 Managerial Economics
9–3. What is the relation between a dominant strategy and a Nash equilibrium?
9–4. In this chapter we gave an example of coordination problems in the market for HDTVs. Show the game in strategic form using hypothetical payoffs of your choice. Use the arrow
technique to identify the equilibria.
9–5. Some foolish teenagers play “chicken” on Friday nights. Two teenagers drive their cars at each other at high speeds. The first to swerve to the side is the “chicken” and loses. If both
swerve out of the way, they are both chickens and both lose. Neither of the drivers wants to
get into an accident. It causes a significant loss in utility (possibly death). However, both do
not want to be known as a chicken. This causes some loss in utility. What is the equilibrium of
this game? Do you think the two drivers will necessarily produce an equilibrium outcome?
Do you think the chances are better or worse for achieving an equilibrium outcome if the two
players know each other? Explain. Do you think it matters whether the two players have
played the game before? Explain.
9–6. Two basketball players, Barbara and Juanita, are the best offensive players on the school’s team. They know if they “cooperate” and work together offensively—feeding the ball to
each other, providing screens for the other player, and the like—they can each score 12
points. If one player “monopolizes” the offensive game, while the other player “cooper-
ates,” however, the player who monopolizes the offensive game can score 18 points, while
the other player can only score 2 points. If both players try to monopolize the offensive
game, they each score 8 points. Construct a payoff matrix for the players that captures the
essence of the decision of Barbara and Juanita to cooperate or monopolize the offensive
game. If the players play only once, what strategy do you expect the players to adopt? If the
players expect to play in many games together, what strategy do you expect the players to
adopt? Explain.
9–7. General Electric has frequently placed managers together to work on teams. Often the work assignment is only for a short period of time. General Electric makes sure that the quality of
an employee’s performance on a given assignment is recorded and shared with future teams.
Why do you think they do this?
9–8. Some managers commit undetected fraud in producing financial statements. Presumably, if the auditors were really diligent and the penalties for fraud were high enough, there would be
no fraud. Does this mean that the accounting firms are not doing a good enough job in audit-
ing? Explain.
9–9. A labor leader has announced that her union will go on strike unless you grant the workers a significant pay raise. You realize that a strike will cost you more money than the pay raise.
Should you concede to the wage increase? Explain.
9–10. Suppose you are one of two producers of tennis balls. Both you and your competitor have zero marginal costs. Total demand for tennis balls is
P � 60 � Q
where Q � the sum of the outputs of you and your competitor. a. Suppose you are in this situation only once. You and your competitor have to announce
your individual outputs at the same time. You expect your competitor to choose the
Nash equilibrium strategy. How much will you choose to produce and what is your
expected profit?
b. Now suppose that you have to announce your output before your competitor does. How much will you choose to produce? What is your expected profit? Is it an advantage or a
disadvantage to move first? Explain.
9–11. You are considering placing a bid over the Internet in an eBay auction for a rare oriental rug. You are not a dealer in these rugs, and you do not have a precise estimate of its mar-
ket value. You do not want to buy the rug for more than its market value. However, you
would like to buy it if you can get it below the market value. You expect that many peo-
ple will participate in the auction (including rug dealers). eBay asks that you give them
Chapter 9 Economics of Strategy: Game Theory 323
the maximum bid you are willing to make. They will start low; whenever you are outbid,
they will raise your bid just enough to lead the auction. eBay quits bidding on your be-
half once your maximum price is reached. Your best guess at the market value is $1,000.
What should you bid?
9–12. Formulate the following situation as an extensive form game (using a game tree) and solve it using backward induction. Bingo Corporation and Canal Corporation are the only com-
petitors in the electronic organizer industry. Bingo Corporation is considering an R&D
investment to improve its product. Bingo can choose from three levels of investment: High,
Medium, and Low. Following Bingo’s investment, Canal Corporation will have to choose
between continuing to compete by selling its current product or undertaking an R&D
project of its own. Canal can only choose one level of investment, so its choices are Invest
or Not Invest. The net payoffs to Bingo if it invests High, Medium, or Low given that Canal
chooses to Invest would be $50, $40, and $30, respectively, and the corresponding net pay-
offs to Canal would be $5, $10, and $15. On the other hand, the net payoffs to Bingo if it
invests High, Medium, or Low given that Canal chooses to Not Invest would be $100, $80,
and $60, respectively, and the corresponding net payoffs to Canal would be $0, $15, and
$20. What will Bingo choose to do in equilibrium, and what will Canal’s response be?
Appendix: Prisoners’ dilemmas occur when it is in the joint interests of the parties to coop- Repeated erate but individual incentives motivate an equilibrium where they fail to cooper- Interaction ate. Situations of this type occur frequently both between and within business and the firms. This appendix provides an example of how cooperation sometimes can be Teammates’ achieved when the decision makers are confronted with this same dilemma on a Dilemma19 repeated basis. The example highlights the factors that are important in determin-
ing whether cooperation will be achieved in a repeated setting. Managerial impli- cations are discussed.
Much of the analysis in this chapter has focused on interaction between rival firms. This example focuses on the interaction between two employees assigned to a team and is chosen to illustrate the wide applicability of the analysis of strategic in- teractions.
The Example Anne van Gastel and Bert Dijkstra work on a production team. They want to agree to a “contract” that both will work hard so that they can earn a bonus. They face a problem in that the contract is not legally binding and effort is not contractible. This problem is similar to the prisoners’ dilemma introduced in Chapter 6 as well as several examples in this chapter (e.g., the pricing problem between Boeing and Airbus).
Figure 9.8 displays the possible payoffs for this teammates’ dilemma. If Anne and Bert both shirk, they receive salaries of $1,000. If both work hard, they re- ceive a bonus. However, they experience disutility from the additional effort. The payoffs, net of this disutility, are $2,000 each. If Bert shirks and Anne works hard, they meet their production target and receive bonus payments. Bert, however, ex- periences no disutility from working hard and receives a payoff of $3,000. Anne also receives a cash bonus. However, being the only one to exert effort, she incurs a back injury. Her net payoff is $0. The opposite payoffs occur if Bert works and Anne shirks.
19This appendix modifies and extends an example in G. Miller (1992), Managerial Dilemma: The Political Economy of Hierarchy (Cambridge University Press: Cambridge), 184–186. It requires knowledge of basic statistics.
324 Part 2 Managerial Economics
The Nash equilibrium in a single-period setting is for both to shirk. Given the pay- offs, it is always in their individual interests to shirk. If Anne works, Bert is better off shirking since he receives $3,000 rather than $2,000. Similarly, if Anne shirks, Bert would rather receive the $1,000 from shirking than the $0 payoff from working. This same logic holds for Anne. This equilibrium outcome is not efficient. Both Bert and Anne would prefer the outcome where they both work—there, payoffs are $2,000 instead of $1,000. The problem is that they can’t observe each other’s effort until after the work is complete.
Now suppose that Bert and Anne expect to work together in the future. In particu- lar, suppose that in a given period there is a probability p that they will work together in the next period.20 Thus, the probability that they will work together through n pe- riods is p n�1. Now suppose that Bert and Anne each consider only two options in choosing their effort levels. One is to follow the strategy of always shirking every period. If both Bert and Anne select this strategy, the expected sum of each person’s future earnings will be21
E(future earning) � $1,000 � $1,000p � $1,000p2. . . (9.1)
Figure 9.8 Payoffs to Two Members in a Single-Period Setting
The payoff on the upper left in each cell is the payoff for Anne, and the payoff on the lower right is for Bert. If Bert and Anne both shirk, they receive salaries of $1,000. If they both work hard, they receive a bonus. However, they experience disutility from working hard. The payoff, net of this disutility, is $2,000. If Bert shirks and Anne works hard, they meet their production target and receive a payoff of $3,000. Bert also receives a cash bonus. However, being the only one to exert effort, Anne incurs a back injury. Her net payoff is $0. The opposite payoff occurs if Bert works and Anne shirks. The Nash equilibrium in this single-period setting is for both to shirk (shaded cell). Given the payoffs, it is always in their individual interests to shirk.
$1,000
$1,000
Bert—Shirks
Bert—Shirks
Bert—Works
Bert—Works
A n
n e
— W
o rk
s
A n
n e
— W
o rk
s
A n
n e
— S
h ir
ks
A n
n e
— S
h ir
ks
$3,000
$0
$3,000
$0
$2,000
$2,000
20In each period, Bert and Anne choose an effort level, observe output, and receive compensation from the
firm. 21For simplicity, we ignore discounting future cash flows. Also, the formulation assumes that Bert and Anne
have the possibility of living forever. Neither of these simplifications is crucial for our analysis.
Chapter 9 Economics of Strategy: Game Theory 325
This expression is an infinite sum with a value of $1,000 [1�(1 � p)]. The other strat- egy, known as tit-for-tat, is to work hard the first period and thereafter mimic their teammate’s previous choice. For instance, if Bert works hard in the first period and Anne shirks, Bert will shirk in the second period. If one person shirks in the first period, then in all future periods both people shirk (the person who selects to shirk in the first period has chosen the strategy of always shirking).22
Both Bert and Anne want to maximize the expected sum of their individual future earnings from the working relationship. Figure 9.9 shows the generalized payoffs in the setting. Unlike the single-period case, it does not always pay a person to shirk. Clearly, if Anne expects Bert to shirk, she will shirk as well, since $1,000�(1 � p) is always greater than �$1,000 � $1,000�(1 � p).23 However, if Anne thinks that Bert is going to choose the tit-for-tat strategy, it can be in her interest to do so as well. Her expected payoff from selecting tit-for-tat is $2,000�(1 � p). Thus, she will select tit- for-tat whenever p is greater than 1�2—since $2,000�(1 � p) is greater than $2,000 � $1,000�(1 � p). Symmetric logic holds for Bert’s choice.
22Players adopting tit-for-tat strategies can get stuck in inefficient cycles of alternating honoring and cheating
after a player makes a mistake, either in assessing the other player’s choice or in choosing his own strategy
in a single period (each player reacting to the other player’s previous choice). Economists have suggested
slight modifications that overcome this and several other conceptual problems with tit-for-tat. We
concentrate on tit-for-tat since it is easy to explain and conveniently highlights the major factors that are
likely to favor cooperative outcomes. 23The payoff from tit-for-tat is [$0 � ($1,000p � $1,000p2 . . .)] � [�$1,000 � $1,000 � ($1,000p �
$1,000p2 . . .)] � �$1,000 � $1,000�(1 � p).
Figure 9.9 Generalized Payoffs for Two Members in a Multiperiod Setting
Anne and Bert each consider two options in choosing their effort levels. One is to follow the strategy of always shirking every period. The other strategy, known as tit-for-tat, is to work hard for the first period and thereafter mimic their teammate’s previous choice. For instance, if Bert works hard in the first period and Anne shirks, Bert will shirk in the second period. If one person shirks in the first period, then in all future periods both people shirk (the person who selects to shirk in the first period has chosen the strategy of always shirking). The upper-left payoff in each cell is Anne’s, and the lower-right payoff is Bert’s. In a given work period, there is a probability p that they will work together in the next period.
$1,000 1−p
Bert—Always shirks Bert—Tit-for-tat
Bert—Tit-for-tatBert—Always shirks
A n
n e
— A
lw a
ys s
h ir
ks
A n
n e
— A
lw a
ys s
h ir
ks
A n
n e
— T
it -f
o r-
ta t
A n
n e
— T
it -f
o r-
ta t
$1,000
1−p
$1,000 1−p
$2,000 1−p
$2,000 1−p
$2,000 +
$1,000
1−p −$1,000 +
$1,000
1−p −$1,000 +
$1,000
1−p $2,000 +
326 Part 2 Managerial Economics
Figures 9.10 and 9.11 show the payoffs for Bert and Anne for the cases, where p � 1�3 and p � 3�4. When p � 1�3, the Nash equilibrium is for both to shirk— the probability of repeated interaction is not large enough to promote cooperation. This example illustrates the general point that reputational concerns are unlikely to promote cooperation when the relationship is expected to be short-term. In the second case, two equilibria are possible: mutual shirking or mutual cooperation.
The existence of multiple equilibria when p � 3�4 suggests that Bert’s and Anne’s initial expectations are important. For instance, if Bert expects Anne to shirk, he will shirk as well. However, if he expects her to choose tit-for-tat, it makes sense for him to select the same strategy. Anne has similar incentives. Thus, the ef- ficient outcome—for both to work—will occur when there is a mutual expectation that both will work hard. This example suggests that businesses might promote co- operation by fostering particular expectations among employees. For instance, sup- pose the company publicizes in a credible manner that its employees have a long record of mutual cooperation. The firm might also invest in developing a reputation for hiring talented, motivated people who are unlikely to shirk. Given this “corpo- rate culture,” it is reasonable for Bert to expect that Anne will select tit-for-tat. Anne will have similar expectations. Both will select tit-for-tat, and the corporate culture is reinforced.
Figure 9.10 Payoffs for Two Team Members of a Production Team When the Likelihood of Working Together in the Future Is Low ( p � 1�3)
Bert and Anne each consider two options in choosing their effort levels. One is to follow the strategy of always shirking every period. The other strategy, known as tit-for-tat, is to work hard for the first period and thereafter mimic their teammate’s previous choice. For instance, if Bert works hard in the first period and Anne shirks, Bert will shirk in the second period. If one person shirks in the first period, then in all future periods both people shirk (the person who selects to shirk in the first period has chosen the strategy of always shirking). The payoff on the lower left in each cell is Anne’s payoff, while the payoff on the lower right is Bert’s. In a given work period, there is a probability p that they will work together in the next period. In this example, the probability of working together in the future is relatively small (1�3). The circle technique indicates that the Nash equilibrium is for both to shirk (shaded cell).
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Chapter 9 Economics of Strategy: Game Theory 327
We have shown that the expected length of the relationship is important in deter- mining the level of cooperation. So are the expected payoffs. For instance, if the pay- offs from mutual shirking are increased to $1,500, the probability of working to- gether in the next period must be 2�3 to promote cooperation. Alternatively, if the payoffs from mutual cooperation are $2,500, the required probability falls to 1�3. These examples illustrate the general principles that reputational concerns will work best at resolving incentive problems when the short-term gains from cheating are small and when the gains from continued cooperation are large.
Another factor that is important is the likelihood of being caught shirking. In this example, shirking is observed perfectly before the next period. If Bert and Anne do not know for certain that the other person has shirked, they might continue to co- operate even if the other person has shirked. In this case, the temptation to shirk will be greater.
Managerial Implications Recently, managers have delegated more work assignments to teams. Problems like the one in this example can reduce team output and the firm’s value. Managers can limit these problems and promote cooperation among team members by structuring
Figure 9.11 Payoffs for Two Team Members of a Production Team When the Likelihood of Working Together in the Future Is High ( p � 3�4).
Bert and Anne each consider two options in choosing their effort levels. One is to follow the strategy of always shirking every period. The other strategy, known as tit-for-tat, is to work hard for the first period and thereafter mimic their teammate’s previous choice. For instance, if Bert works hard in the first period and Anne shirks, Bert will shirk in the second period. If one person shirks in the first period, then in all future periods both people shirk (the person who selects to shirk in the first period has chosen the strategy of always shirking). The payoff on the lower left in each cell is Anne’s payoff, and the payoff on the upper right is Bert’s. In a given work period, there is a probability p that they will work together in the next period. In this example, the probability of working together in the future is relatively high (3�4). The arrow technique indicates that two Nash equilibria exist. One is mutual shirking; the other mutual tit-for-tat (both cells are shaded).
$4,000
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328 Part 2 Managerial Economics
rewards (e.g., bonuses) that are high if team members cooperate and low if they do not. Also, managers must be careful not to change team composition too frequently: Incentive problems are larger when team members do not expect to work together in the future.
Analyzing Managerial Decisions: Restructuring The BQM Company frequently restructures. Employees regularly are transferred among departments and given different job assignments. Management argues that this action promotes a better trained and more responsive workforce. Do you see po- tential problems with this type of frequent restructuring? Does this mean that BQM is making a mistake? Explain.
chapter
10 C H A P T E R O U T L I N E
Firms
Incentive Conflicts within Firms
Owner-Manager Conflicts
Other Conflicts
Controlling Incentive Problems through Contracts
Costless Contracting
Costly Contracting and Asymmetric Information
Postcontractual Information Problems
Precontractual Information Problems
Implicit Contracts and Reputational Concerns
Incentives to Economize on Contracting Costs
Summary
A very large corporate takeover occurred in 1988—the purchase of RJR-Nabisco by Kohlberg, Kravis, Roberts & Company. Public accounts report lavish expenditures and decisions of questionable merit by RJR executives preceding the takeover. For example,
Burrough and Helyar in their best seller Barbarians at the Gate write,
It was no lie. RJR executives lived like kings. The top 31 executives were paid a total of $14.2 million, or an average of $458,000. Some of them became legends at the Waverly for dispensing $100 tips to the shoeshine girl. [Ross] Johnson’s two maids were on the company payroll. No expense was spared decorating the new headquarters, highlighted by the top-floor digs of the top executives. It was, literally, the sweet life. A candy cart came around twice a day dropping off bowls of bonbons at each floor’s reception areas. Not Baby Ruths but fine French confections. The minimum perks for even lowly middle managers was one club membership and one company car, worth $28,000. The maximum, as nearly as anyone could tell, was Johnson’s two dozen club memberships and John Martin’s $105,000 Mercedes.
In addition, it appears that major investment decisions at RJR often were dri- ven by the preferences of managers rather than by value maximization. For instance, Ross Johnson, CEO of RJR, reportedly continued to invest mil- lions of dollars in developing a smokeless cigarette long after it was obvious that the project would never be profitable.
Incentive Conflicts and Contracts
L E A R N I N G O B J E C T I V E S
1. Define the firm as a focal point for a set of contracts. 2. Identify important owner-manager conflicts, as well as other potential stake-
holder conflicts.
3. Explain how contracts can be used to help control incentive problems. 4. Explain how asymmetric information can increase the costs of contracting. 5. Differentiate between adverse selection problems and moral hazard problems. 6. List the components of agency costs. 7. Discuss how implicit contracts and reputational concerns can sometimes reduce
incentive problems and contracting costs.
8. Explain why all the firm’s stakeholders potentially have a common interest econ- omizing on contracting costs.
330 Part 2 Managerial Economics
More recently other executives have been charged with even more extreme exam- ples of excessive behavior. For example, in July 2002, the U.S. Justice Department charged that John Rigas and his two sons “looted Adelphia on a massive scale” and used it as a “personal piggy bank.” Over the past five decades Rigas had built a small cable company in rural Pennsylvania into Adelphia Communications—listed on Nasdaq and the sixth largest U.S. cable company. The government’s complaint charged the Rigas family with using Adelphia’s assets to buy company stock, timberland, New York condos, and a National Hockey League team; to build a golf course on family-owned property; to bankroll movies produced by a Rigas’ daughter; and to pay for automobiles on behalf of a Rigas-owned dealership.1 Rigas was subsequently convicted and sentenced to a 15-year jail term. He is scheduled to be released from prison in 2018.
The behavior of RJR and Adelphia executives raises at least four interesting issues:
• In previous chapters, we assumed that managers always maximize profits. Ap- parently, they do not. To understand management problems within the firm, we need a richer characterization of the firm and managerial decision making.
• Both RJR and Adelphia suggest that material conflicts of interest can exist be- tween owners and managers: Shareholders are interested in the firm’s value, whereas the managers are interested in their own utility. What other conflicts of interest exist within firms?
• These cases suggest that owner-manager conflicts can result in reduced pro- ductivity and waste. Unchecked, such conflicts of interest can destroy a firm. How do firms limit unproductive actions to enhance value and avoid failure?
• If techniques to limit unproductive actions exist, why did the owners (share- holders) at RJR and Adelphia allow the managers to engage in such dysfunc- tional behavior?
In this chapter, we examine these and related issues. We begin by enriching our un- derstanding of the definition of a firm. We then use this more explicit understanding to discuss various conflicts of interest that exist within firms. Next, we examine how contracts help reduce or control these conflicts. We focus particular attention on the problems created by costly information. Finally, we discuss how reputational con- cerns can control incentive conflicts within firms.
Firms In Chapter 3, we characterized the firm in terms of administrative decision making: Markets use prices to allocate resources; firms use managers. This prompted a dis- cussion of the relative efficiency of firms and markets. Thus far in the book, we have treated the firm as if it had one central manager who acts to maximize the firm’s value. This characterization is employed widely in economics and has proved quite useful in explaining production and pricing decisions.
1D. Lieberman and G. Farrell (2002), “Five Former Adelphia Arrested,” USA Today ( July 24); R. Grover (2002), “Adelphia vs. Deloitte in a Game of Blame,” BusinessWeek Online ( June 27); and R. Farzad (2005), “Jail Terms for 2 at Top of Adelphia,” New York Times ( June 21), C1.
Chapter 10 Incentive Conflicts and Contracts 331
The actual decision-making process within firms, however, is extremely complex and differs from this simple characterization in at least three ways. First, there are many decision makers within firms. In large corporations, the board of directors makes major policy decisions including appointing the CEO. The CEO, in turn, re- tains certain important decision rights while delegating many operating decisions (for instance, pricing, production, and financing decisions) to lower-level managers. Even the lowest-paid employee in the firm usually has some decision-making authority. Second, the primary objective of most of these decision makers is not to maximize the value of the firm: The investment behavior of the RJR executives certainly suggests interests in things other than corporate value maximization. Third, firms often use in- ternal pricing systems (transfer prices) to allocate internal resources.
Analyzing organizational issues within the firm requires a richer concept of the firm. Several useful definitions have been developed by economists.2 We focus on
one definition that is particularly useful for our purposes3: The firm is a focal point for a set of contracts. This definition focuses on the fact that the firm ultimately is a creation of the legal system; it has been granted the legal standing of an individual (it can enter con- tracts, sue, be sued, and so on). The term focal point indicates that the
firm always is one of the parties to each of the many contracts that constitute the firm. Examples of these contracts are employee contracts, supplier contracts, cus- tomer warranties, stock, bonds, loans, leases, franchise agreements, and insurance contracts. This contract view of the firm is depicted in Figure 10.1.
Some contracts are explicit legal documents, whereas many others are implicit. And even within a relationship that has been formalized with an explicit contract,
Employees Suppliers Labor unions
Insurance providers The firm Stockholders
Bondholders Banks Customers
Figure 10.1 The Firm as a Focal Point for a Set of Contracts
The firm is a creation of the legal system that has the standing of an individual in a court of law. The firm serves as one party to the many contracts that make up the firm.
Definition The firm is a focal point for a set of contracts.
2O. Hart (1989), “An Economist’s Perspective on the Theory of the Firm,” Columbia Law Review 89, 1757–1774.
3M. Jensen and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure,” Journal of Financial Economics 3, 305–360.
332 Part 2 Managerial Economics
there is a broad array of aspects of the relationship that are not spelled out within the written agreement—they are implicit. An example of an implicit contract is an em- ployee’s understanding that if a job is done well, it will result in a promotion. Im- plicit contracts are often difficult to enforce in a court of law. Later in this chapter, we discuss how reputational concerns can help ensure that individuals honor implicit contracts.
Incentive Conflicts within Firms4
Economic theory characterizes individuals as creative maximizers of their own util- ity. Thus, the collection of individuals that contract with the firm are not likely to have objectives that are automatically aligned. The owners of the firm have title to the residual profits (what is left over after other claimants are paid) and are likely to be interested in maximizing the present value of these profits. Other individuals within the firm do not share this goal necessarily. In this regard, the corporation is more like a market than a person. One sometimes hears statements like “GM would like to raise car prices.” Although GM shareholders, managers, and other employees might favor higher automobile prices, GM’s customers (including franchise dealers) undoubtedly would not. If someone stated that the wheat market favored higher prices, the statement would produce confusion. Suppliers in the wheat market would favor higher prices while demanders would not. Similarly, within firms the incen- tives of the contracting parties often conflict with one another. We now discuss some of the more important incentive conflicts that arise within firms. We then discuss how contracts can be used to reduce and control these conflicts.
Owner-Manager Conflicts
Owners often delegate the management of firms to professional managers. For in- stance, in large corporations, the residual profits are owned by shareholders who del- egate significant decision authority to top executives. At least five sources of conflict arise between owners and managers:
• Effort Choice. Additional effort by managers generally increases the value of the firm, but since the managers expend the effort, additional effort reduces their utility.
• Perquisite taking. It is in the interests of owners to pay sufficient salaries and bonuses to attract and retain competent managers. However, owners do not want to overpay managers. In contrast, managers are likely to want not only higher salaries but also perquisites such as exclusive club memberships, lavish office furniture, luxurious automobiles, stimulating day care for children, and expensive French confections.
• Differential risk exposure. Managers typically have substantial levels of human capital and personal wealth invested in the firm. This large investment can make managers appear excessively risk-averse from the standpoint of the owners, who (at least in a large public corporation) typically invest only a
4This section draws on M. Jensen and C. Smith (1985), “Stockholder, Manager, and Creditor Interests:
Applications of Agency Theory,” in E. Altman and M. Subrahmanyam (Eds.), Recent Advances in Corporate Finance (Irwin Professional Publishers: Burr Ridge), 95–131.
Chapter 10 Incentive Conflicts and Contracts 333
small fraction of their wealth in any one firm.5 Hence, managers might forgo projects that they anticipate would be profitable simply because they do not want to bear the risk that the project might fail and lead to a reduction in their compensation.
• Differential horizons. Managers’ claims on the corporation generally are lim- ited by their tenure with the firm. Therefore, managers have limited incentives to care about the cash flows that extend beyond their tenure. Owners, on the other hand, are interested in the value of the entire future stream of cash flows, since it determines the price at which they can sell their claims in the company.
• Overinvestment. Managers can be reluctant to reduce the size of a firm, even if it has exhausted available profitable investment projects; they prefer to em- pire build. Also, managers often are understandably reluctant to lay off col- leagues and friends in divisions that are no longer profitable. Managers who fire their colleagues bear personal costs (disutility), whereas shareholders re- ceive most of the benefits.
M A N A G E R I A L A P P L I C AT I O N S
The Spectrum of Organizations The firm can be viewed as a focal point for a set of contracts. One, particularly, important feature of these contracts is
the distribution of the residual profits. Organizations vary remarkably along this dimension. In a sole proprietorship
like Esptein’s Deli, the owner/manager is the residual claimant. In a partnership like the law firm of Nixon-Peabody,
the claims are shared by the partners. In a large public corporation like Amazon.com, these claims often are held by
thousands of shareholders who take little direct interest in managing the company. In a mutual like the Prudential
Insurance Company, ownership and customer claims are merged. In a cooperative like Ocean Spray, supplier and
ownership claims are merged. In an employee-owned firm like United Airlines, the claims are owned by the
employees. Finally, in a not-for-profit institution like the American Red Cross there are no owners of the residual cash
flows. In most of these large organizations, management authority is delegated to professional managers, who often
have small or no ownership positions in the organization. According to Coase, individuals have incentives to select the
form of organization that minimizes total contracting costs (see Chapter 3).
Our discussion of conflicts between owners and managers suggests that problems arise in public corporations
because of the separation of ownership and control. These problems are costly to resolve. Given these costs, what are the
offsetting benefits that promote the prominence of large corporations? One of the most significant benefits is that capital
is raised from many investors who share in the risk of the company. Individual shareholders place only a small amount
of their wealth in a given company, and thus avoid “placing all their eggs in one basket.” This diversification makes risk-
averse investors (see Chapter 2) willing to supply capital to corporations at a lower cost. This benefit, however, comes at
the cost of having to control the incentive conflicts between managers and owners. Thus, in smaller operations, where
raising large amounts of capital is less of an issue, one should expect to find sole proprietorships and small partnerships
(where there is less separation of ownership and control). Indeed, this is what is observed.*
*There are also tax-related reasons that affect the choice of organizational form.
Source: M. Scholes, M. Wolfson, M. Erickson, and M. Hanlon (2014) Taxes and Business Strategy (Prentice-Hall: Englewood Cliffs).
5To be more precise, we do not assume that the underlying preferences (utility functions) of owners and
managers differ. Rather we focus on the fact that the risk of owners’ claims on public firms can be managed
more easily through diversification than can those of managers. The most valuable component of most
managers’ wealth is their human capital, and managers typically have but one job.
334 Part 2 Managerial Economics
Other Conflicts
Similar types of incentive conflicts are likely to arise among most contracting parties in the firm. For example, top managers worry about effort and perquisite-taking problems with lower-level employees. The firm’s creditors and shareholders can have disputes over the optimal dividend, financing, and investment policies of the firm. Firms can have incentives to default on warranties with customers. Managers often quarrel with labor unions. For example, Alcatel-Alsthom SA, a French conglomerate, was unable to divest any of its low-margin plants without engender- ing an uproar from its unions.6
Owners of firms would like to acquire high-quality inputs at low prices, whereas owners of supplying firms would like to provide inexpensive inputs at high prices. This tension produces conflicts between buyers and suppliers. Supplying firms worry about buying firms demanding price concessions, and buying firms worry that suppliers will either shirk on quality (to reduce cost) or raise prices.
Incentive conflicts also arise with joint ownership. For example, in a large ac- counting firm, the actions of each partner affect the profits of the organization, which are shared among the partners. This arrangement can motivate partners to free-ride on the efforts of others. Each partner hopes the other partners will work diligently to keep the firm profitable. However, each partner has an incentive to shirk: Individual partners gain the full benefit of their shirking but bear only part of the costs (their share of the reduced profits). Free-rider problems are common in most group activi- ties and, if left unchecked, greatly reduce the output of teams. (We shall refer to such free-rider problems throughout the rest of this book.)
Controlling Incentive Problems through Contracts What keeps these incentive conflicts from undermining cooperative undertakings and destroying all organizations? For example, might the fear that managers will use all company resources for their personal benefit dissuade owners from delegating
M A N A G E R I A L A P P L I C AT I O N S
Buyer-Supplier Conflicts Immediately after the United States invaded Iraq, the U.S. military hired Halliburton to supply the U.S. troops in Iraq with
supplies. One contract involved the provision of gasoline. The contract terms stated that Halliburton would be reimbursed
for its costs plus receive a 1 percent profit margin. The problem with such cost-plus contracts is that they provide little
incentive for the supplier to control costs, or to pick the most competitive subcontractors, since the higher the costs, the
higher the profits to the supplier (Halliburton in this case). The Pentagon investigators charged that Halliburton purchased
gasoline at almost double the market value after only receiving bids from two other gasoline suppliers. In 2005, the
Defense Contract Audit Agency of the Pentagon and the U.S. Congress investigated the charges without coming to a
definitive resolution.
Source: N. King, Jr. (2004), “Halliburton Says Two Employees Took Kickbacks for Iraq Contracts,” The Wall Street Journal ( January 23), A1, A5; and R. Klein (2005), “Audit Questions $1.4b in Halliburton Bills,” Boston Globe ( June 28), www.boston.com.
6D. Lavin (1998), “Union and Regulators Restrain Alcatel’s Restructuring,” The Wall Street Journal (August 7), A8.
Chapter 10 Incentive Conflicts and Contracts 335
operating authority to managers?7 Fortunately, there are mechanisms that help con- trol incentive conflicts. Among the most important are contracts.8
Contracts (both implicit and explicit) define the firm’s organizational architecture— its decision right, performance evaluation, and reward systems. This architecture provides an important set of constraints and incentives that helps resolve incentive problems. For instance, if a contract specifies that Erin O’Malley, the firm’s chief financial officer, will receive an annual salary of $200,000, she can be fired if she unilaterally pays herself more: She does not have the decision right to set her own compensation.9 If Erin is evaluated on firm profits and rewarded with a large bonus for good performance, she has incentives to care about the firm’s profits.
Costless Contracting
Under some circumstances, contracts can resolve incentive problems at low cost. As an example, consider Jerold Concannon, CEO of the Bagby Printing Company. Jerry gains utility U, from both his monetary compensation C and perquisites P such as company expenditures on luxury cars and club memberships:
U � f (C, P ) (10.1)
If the firm provides no perquisites to Jerry, it must pay him a salary S in cash compensation; otherwise, he will work for another firm. The owners of the firm are
M A N A G E R I A L A P P L I C AT I O N S
Experimental Evidence on Free-Rider Problems Over a century ago a German scientist named Ringelmann asked workers to pull as hard as they could on a rope attached
to a meter that measured the strength of their efforts. Subjects worked alone as well as in groups of two, three, and eight.
While the total amount of force on the rope increased as group size rose, the amount of effort by each person seemed to
drop. While one person pulling alone exerted an average of 63 kg of force, this dropped to about 53 kg in groups of three and
was reduced to about 31 kg in groups of eight. The greater the number of people performing the task, the less effort each one
expended.
The impact of any social force directed toward a group from an outside source (e.g., a manager) is divided among
its members. Thus, the more persons in the group, the less the impact such force will have upon each. Because they are
working with others, each group member feels [that others] will take up any slack resulting from reduced effort on
their part. And since all members tend to respond in this fashion, average output per person drops sharply.
Source: B. Kantowitz, H. Roediger and D. Elmer (2014), Experimental Psychology, 19th edition (Cengage Learning: Independence, KY).
7In fact, some authors suggest that this concern ultimately will cause the collapse of the public corporation.
See A. Berle and G. Means (1932), The Modern Corporation and Private Property (Macmillan: New York). 8Other important mechanisms are the market for corporate control and the product market. Managers have
incentives to increase a firm’s profits because firms with inefficient managers can be taken over by other
firms and the management team replaced. Indeed, this is what happened at RJR-Nabisco. Also, inefficient
firms eventually go out of business in a competitive market. 9Restricting an agent’s decision-making authority can reduce incentive problems. However, it also can mean
that authority has not been granted to the individual with the best knowledge to make the decision. This
tension is a fundamental concern in designing organizational architecture and is a central focus of Chapter 11.
336 Part 2 Managerial Economics
willing to pay Jerry S if he consumes no perquisites. However, as CEO, Jerry has numerous opportunities to consume company resources. These opportunities pre- sent an incentive problem: Jerry would like to spend company resources on himself, whereas the owners do not want Jerry to reduce the firm’s value by consuming ex- cessive perquisites. As we will see, some amount of perquisites actually increases value. But beyond this level of perquisite consumption, value falls.
Suppose for now that the owners of the firm have precise knowledge of the max- imum potential profit of the firm, �M (if Jerry is paid S and consumes no perquisites). In this case, realized profits of the firm, �R (if he is paid S and con- sumes perquisites, P ) are the difference between maximum profits and Jerry’s excess perk consumption:
�R � �M � P (10.2)
With this information, the owners can solve the potential incentive problem by of- fering Jerry the following compensation contract:
C � S � (�M � �R ) (10.3)
This contract, which reduces Jerry’s salary by the difference between realized and maximum profits, is equivalent to charging Jerry the full cost of his perquisites—that is, C � S � P.
Figure 10.2 displays Jerry’s choice of perquisites. His objective is to maximize his utility subject to the constraint that he is paid according to his compensation plan. Jerry chooses the combination (C*, P*), which occurs at the tangency point between his indifference curve and the compensation constraint. This combination
M A N A G E R I A L A P P L I C AT I O N S
Incentive Conflicts Around the World Incentive conflicts are not just an American business phenomenon, nor do they occur only in private firms. Rather,
these conflicts exist in all types of organizations throughout the world.
In July 2013, the largest corporate governance scandal in Japanese history ended when the former chairman of the
board and two other top executives of the Olympus Corporation, a multinational optical equipment manufacturer,
pleaded guilty to charges of falsifying accounts to cover up losses of $1.7 billion. All three executives received prison
sentences, ranging from 2.5 to 3 years.
The scandal surfaced in October 2011 when Michael Woodruff was ousted as CEO of Olympus. He had questioned
the board of directors about large, irregular payments that they had authorized to financial advisors in corporate
acquisitions. He wanted to have an accounting firm audit the transactions. The board responded by quickly firing him.
Woodruff did not leave the company quietly. He immediately left for London and provided the British Serious
Fraud Office a file containing information on the transactions. He suggested that the potentially illegal payments were
linked to the Board of Directors and the scandal continued to grow. Press coverage accelerated. Over the period from
October 12 to November 12, 2011, Olympus’ stock price fell from a price of 2,500 yen to 500 yen—an 80 percent
decline. Olympus board members resigned in mass and the financial statements were ultimately restated. Criminal
charges were filed against the former top executives/board members. The scandal raised investor concerns about
corporate governance practices throughout Japan.
Source: BBC News Business (2013), “Olympus scandal: Former executives sentenced,” www.bbc.com (July 3).
Chapter 10 Incentive Conflicts and Contracts 337
places Jerry on the highest indifference curve possible given the compensation plan. This choice is Pareto-efficient. The owners are indifferent to Jerry’s choice: They always pay the equivalent of S (they pay him S � P in cash and P in perquisites). Jerry, however, is better off being able to choose the combination of salary and perks that he prefers. For example, Jerry had a back injury and prefers a more expensive, ergonomically designed desk chair to the company’s standard office furniture, even though he knows that his compensation is reduced to reflect the additional expense. Also, Jerry might prefer a combination of salary and perquisites to a pure salary because perks frequently are untaxed.10
Note how the compensation plan aligns Jerry’s and the owners’ incentives. Jerry is given the decision right to choose how much the firm spends on his perquisites. The contract, however, charges Jerry the full cost of his perk consumption. In essence, he is rewarded for consuming fewer perquisites. This reward structure gives him private incentives to limit his perk consumption.
In this analysis the owners establish the firm’s total compensation expense asso- ciated with Jerry’s employment, S, Jerry chooses his optimal level of perk con- sumption, P*, and this determines his cash compensation, C* (� S � P*). This
S $
P*
C*
$
S
C a
sh c
o m
p e
n sa
ti o
n
Compensation plan
Expenditures on perquisites
Slope = −1
Figure 10.2 Optimal Perquisite Taking
The manager is paid a cash salary S, as long as the manager maximizes profits. If the manager fails to maximize profits by taking perquisites (e.g., too many club memberships, paying excessive salaries to top subordinates, or buying expensive company cars), the owners reduce the compensation by the amount of the lost profits. Given this compensation scheme, the manager chooses the combination (C*, P*). This choice is Pareto-efficient.
10This tax effect is reflected in Jerry’s indifference curves. Over some range, Jerry is willing to trade more than
a dollar of cash for a dollar’s worth of perquisites because on an after-tax basis, he is better off. Over this
range, the slope of the indifference curve has a slope with an absolute value greater than one. The optimal
choice of salary and perks occurs at the point where the indifference curve’s slope is �1.
338 Part 2 Managerial Economics
mechanism probably seems far-fetched. Yet such an outcome can be approximated closely through negotiation. If at the beginning of the period Jerry negotiates for a perquisite level of P*, the owners recognize that their total compensation expense will be the sum of his cash compensation plus his perk consumption. Thus, they will set his cash compensation at C* (� S � P*).
This example suggests that some perk taking by managers is likely to be efficient (from the standpoint of both the managers and the firm) because some perks increase productivity, as well as because of the differential tax treatment for perquisites and salary. Thus, the perk taking by RJR executives was not necessarily inconsistent with the shareholders’ objective of value maximization. Without the perks, the sharehold- ers might have had to pay higher salaries to attract and retain the management team. Evidence from the stock market, however, suggests that the behavior of RJR execu- tives was excessive. The stock price of RJR went from about $55 per share at the be- ginning of the takeover contest in October 1988 to about $110 per share when the company was taken over. Furthermore, the management team subsequently was re- placed. Thus, the old RJR management team does not appear to have been maximiz- ing the firm’s value.
Costly Contracting and Asymmetric Information
We have shown how, in some cases, well-designed contracts can resolve incentive problems at low cost. Yet the example of RJR suggests that contracts often are un- successful in accomplishing this objective.
Unlike our hypothetical example, contracts in practice are not costless to ne- gotiate, write, administer, or enforce. For instance, suppose that the owners of Bagby Printing delegate executive compensation decisions to its board of direc- tors. In this case, Jerry might be able to convince board members not to enforce his contract to reduce his salary for perk consumption. (Indeed, Ross Johnson
M A N A G E R I A L A P P L I C AT I O N S
Jack Welch’s Perquisites In 1996, General Electric entered into an employment agreement with its then CEO, Jack Welch, to keep him working
until 2000. Rather than taking a “special one-time payment of tens of millions of dollars,” Mr. Welch accepted an
agreement that gave him lifetime access to G.E.’s “planes, cars, offices, apartments, and financial planning.” This is an
example of a CEO trading off cash compensation and perquisites. Since retiring Mr. Welch has used “a palatial
Manhattan apartment complete with wine, flowers, cook, housekeeper and other amenities, as well as access to General
Electric’s Boeing 737 jets, helicopters and a car and driver for Mr. Welch and his wife. Also included were tickets for the
couple at a number of top sporting events and the opera.” Securities and Exchange Commission rules require publicly
traded corporations to disclose any personal benefits over $50,000 or 10 percent of a top executive’s salary plus bonus.
Concerned that such perks might appear excessive, Welch requested G.E. take back many of them and G.E.’s board of
directors agreed. Welch said that he always pays for his personal meals and travel and rarely uses G.E’s seats for cultural
and sporting events.
Source: G. Fabrikant and D. Johnson (2002), “G.E. Perks Raise Issues about Taxes,” New York Times (September 9), C1–C2.
Chapter 10 Incentive Conflicts and Contracts 339
at RJR apparently attempted to keep board members loyal and supportive by pay- ing them large retainers.) Board members participating in such collusion with se- nior managers can be replaced, but only at a cost. Legal fees alone can be sub- stantial for writing and enforcing contracts (Fortune 500 firms were estimated to have spent nearly $210 billion on legal fees in 2008—equal to about one-third of their profits.).11
A major factor limiting the ability of contracts to resolve incentive conflicts is costly information. In contrast to our example, it is unlikely that the owners of Bagby Printing actually would know the profit potential of the firm. Information is likely to be asymmetric: Jerry simply knows more than the owners about the firm’s profit potential as well as his perk consumption. Given this distribution of information, controlling Jerry’s perk taking by using a compensation contract that requires perfect information about the profit potential of the firm clearly is infea- sible.
There are two general types of information problems that arise in contracting. The first problem is informational asymmetries before the contract is negotiated. The second is the problem of informational asymmetries during the implementation of the contract. Below, we elaborate on each of these problems. We begin with the post- contractual problems because of their importance in this text.
ANALYZING MANAGERIAL DECISIONS: Opening a New Restaurant
You are the owner of a small restaurant chain in the
Portland, Oregon, area. All five of your restaurants
employ the same basic business concept and have
similar building designs, menus, and service for-
mats. Each of the outlets has a head manager who
has primary responsibility for the day-to-day oper-
ations at that location. All five of the outlets are
within a 20-mile radius of your central office. You
are actively involved in the business and frequently
meet with your top management staff. You often
spend time at the restaurants during business hours,
visiting with customers and helping to manage the
staff. You pay each of your managers $40,000 per
year and provide them with a package of fringe
benefits (e.g., paid vacation and insurance). Over
the past three years you have also given each of the
managers a $3,000 holiday bonus in December.
Several of your customers moved last year
from Portland to Salt Lake City, Utah. They have
e-mailed you suggesting that you open a restaurant
in Salt Lake. They miss your food, service, and
restaurant format. They believe the new
restaurant would be successful. You have con-
ducted market research and are thinking seriously
about starting the new restaurant. One concern that
you have is that Salt Lake is over 750 miles from
Portland.
1. Discuss the incentive conflicts that are likely
to arise between owners and managers of a
restaurant.
2. You have been able to control these conflicts
relatively well at your existing restaurants.
Do you anticipate that the conflicts will be
easier or harder to control at the new Salt Lake
location?
3. Should you offer the new head manager at
the Salt Lake location the same compensation
contract that you are using for the five man-
agers in Portland?
11J. Henry (2008), “Fortune 500: The Total Cost of Litigation Estimated at One-Third Profits,” elaw Forum (February 1).
340 Part 2 Managerial Economics
M A N A G E R I A L A P P L I C AT I O N S
Technology to Reduce Monitoring Costs Between 1997 and 2001 the percentage of companies recording and reviewing employee phone conversations has
remained constant at around 10 percent. Those monitoring voice-mail messages have remained around 6 percent. But
e-mail and Internet usage monitoring by employers has exploded from 15 percent to 46 percent of large U.S.
companies. Firms are turning to monitoring employee use of e-mail and the Internet for good reason. Various surveys
report that 90 percent of employees surf non-work-related Web sites at the office, 15 percent of employees spend over
two hours a day surfing nonbusiness sites, and 10 percent receive 21 or more personal e-mails. Companies also fear
expensive litigation resulting from an employee accessing sexually explicit material or circulating offensive e-mails.
Firms worried that employees are spending too much time on personal e-mails or surfing non-business-related sites
are turning to technology to reduce the problems. One type of software blocks sites companies want to prevent
employees from accessing, such as sex, gambling, shopping, and job search sites. Other software monitors how long
each employee is online, the Web sites visited, and the time spent on each site. Managers look for unusual patterns and
report them to the employee’s supervisor, who usually talks to the employee and then blocks the sites. Blocking and
usage monitoring software is relatively inexpensive, costing firms about $15 per employee per year.
Source: A. Cohen (2001), “Worker Watchers,” Fortune/CNET Technology Review (Summer), 70–80.
Postcontractual Information Problems
Agency Problems An agency relationship consists of an agreement under which one party, the principal, engages another party, the agent, to perform some service on the princi- pal’s behalf. Many agency relationships exist within firms. Shareholders appoint boards of directors as their agents to oversee the management of firms. Boards dele- gate much of the operating authority to senior executives; they, in turn, assign tasks to lower-level employees. As we have discussed, there is good reason to believe that the incentives of principals and agents are not aligned automatically. There are agency problems: After the contract is set, agents have incentives to take actions that increase their well-being at the expense of the principals. For instance, as in the case of RJR, managers might shirk, consume perquisites, and choose investment and op- erating policies that reduce profits but increase the managers’ expected well-being.
Asymmetric information typically precludes costless resolution of these contract- ing problems. Since the principal cannot observe the actions of the agent costlessly, the agent generally can engage in activities such as shirking and perk consumption without those activities invariably being detected by the principal. Nonetheless, the principal usually can limit such behavior by establishing appropriate incentives for the agent through the contract and by incurring monitoring costs. Also, agents might incur bonding costs to help guarantee that they will not take certain actions or to en- sure that the principal will be compensated if they do (e.g., agents might bond them- selves by purchasing insurance policies that pay the principal in the case of theft). The agent is willing to incur these expenses to increase the amount paid to the agent by the principal for the agent’s services. If it is costly to control these contracting problems, then it generally will not pay for either party to incur sufficient costs to en- sure that the agent will follow the wishes of the principal completely (at some point marginal cost exceeds the marginal benefits of additional expenditures to increase
Chapter 10 Incentive Conflicts and Contracts 341
compliance). The dollar equivalent of the loss in gains from trade that results from this divergence of interests within the agency relationship is known as the residual loss. Total agency costs are the sum of the out-of-pocket costs (monitoring and bond- ing costs) and the residual loss.
Example of Agency Costs To illustrate the concepts of agency costs and asymmetric information, consider Good Tire Company and the Brown & Brown law firm. Good Tire wants outside legal counsel for contracting and litigation, as well as for general legal advice. Brown & Brown is capable of supplying these services.
Good Tire’s marginal benefit, MB, for hours of legal services is
MB � $200 � 2L (10.4)
where L equals the hours per week of legal services provided to the firm. Good Tire faces some important legal issues, and thus the marginal benefits for legal services are quite high for the first few hours. But as these fundamental issues are resolved, the company receives advice on successively less important issues. Therefore, the marginal benefit of additional hours of legal services declines with the total number of hours provided.
Brown & Brown’s marginal cost (MC) for providing additional hours of legal ser- vices is constant at $100 per hour:
MC � $100 (10.5)
Value is maximized—all potential gains from trade between Good Tire and Brown & Brown are realized—at the point where the marginal benefits of legal ser- vices equal their marginal costs:
MB � MC (10.6)
200 � 2L � 100 L* � 50 hours
It is not optimal to provide more than 50 hours of legal services because the marginal benefits would be lower than the marginal costs. Correspondingly, it is suboptimal to provide fewer than 50 hours because the marginal costs of providing additional hours would be lower than the marginal benefits.
Assuming no contracting costs, an optimal contract simply might specify 50 hours per week of legal services. For example, Good Tire could agree to pay Brown & Brown $6,250 a week for 50 hours of legal work. This outcome is pictured in the left panel in Figure 10.3. The total gain from the exchange (surplus) is $2,500, as depicted by the triangle labeled S. At a price of $6,250 for legal services, the gains are split evenly between the two companies.12 The fee covers Brown & Brown’s costs of $5,000 (50 � $100) and provides it with a profit of $1,250. Good Tire receives gross benefits of $7,500. However, it pays a fee of $6,250, yielding net benefits of $1,250. If the two firms negotiate other prices for the 50 hours of legal services, the split in gains would be different. If the market for legal services is
12Recall that total benefits (TB) are equal to the area under the marginal benefit curve, while total costs
(TC) are the area under the marginal cost curve. Thus, at 50 hours of legal service, the total surplus is
S � TB � TC.
342 Part 2 Managerial Economics
perfectly competitive, the price would be $5,000 ($100 per hour), and all gains would go to Good Tire. But as long as total hours are set at 50, the agreement is ef- ficient and total surplus is $2,500.
A potential incentive problem can confound this relationship: It is costly for Good Tire to observe how many hours of legal work Brown & Brown actually pro- vides to the firm (there is asymmetric information). Thus, Brown & Brown might work far fewer than 50 hours but still claim it worked the full amount. Indeed, the problem might be so severe that Good Tire does not hire Brown & Brown at all. In this case, the total potential gains from trade are lost. This contracting cost is a residual loss: The lost surplus that results because it is simply too costly to resolve this incentive problem.
More generally, the two firms might be able to promote a mutually advantageous exchange by controlling this incentive problem through expenditures on monitoring and bonding. For example, Good Tire might spend $400 per week to hire a manager specifically to oversee Brown & Brown’s work, and Brown & Brown might spend $400 per week to document that it is actually conducting legal work for the firm. But it is unlikely that it will pay the two parties to expend sufficient resources to guaran- tee that Brown & Brown will do no overbilling. For example, the end result might be that, after the $800 expenditures on monitoring and bonding, Brown & Brown
Surplus is split at P = $6,250 for 50 hours
LL 4050
MB
MC100
200
S
Sʹ
O R
$ $
MC
MB
Hours of legal services Hours of legal services
M a rg
in a l c
o st
s a n d b
e n e fit
s o f le
g a l s
e rv
ic e s
(i n d
o lla
rs )
Figure 10.3 Agency Costs in Legal Contracting
The left panel shows the marginal benefit (MB) to Good Tire for hours of legal services (L) and the marginal cost (MC) to Brown & Brown for providing these services. Assuming no incentive problems, the optimal number of hours is 50. The total gains from trade, $2,500, are shown by the triangle labeled S. The right panel reflects the contracting costs between the two firms—Brown & Brown might bill for more hours than hours worked. The two firms spend $400 each for monitoring and bonding costs. These out-of-pocket costs are shown by the rectangle labeled O. Since it does not pay to resolve this incentive problem completely, we assume that Brown & Brown ends up providing only 40 hours of legal services. The triangle R represents the residual loss of $100. The original surplus S is reduced by the sum of the out-of-pocket costs and the residual loss. The resulting surplus, labeled S�, is $1,600. How this surplus is split depends on the price charged for the legal services.
Chapter 10 Incentive Conflicts and Contracts 343
provides 40 hours of legal service (more hours than if there were no monitoring/ bonding) and bills for 50 hours. Both parties anticipate this outcome and might ne- gotiate a price of $5,200 for the legal service.13 This price is lower than in the case where information is costless and there are no incentive problems: Good Tire is un- willing to pay as much for the anticipated 40 hours as it would if it were sure it would receive 50 hours of legal services.
The right panel in Figure 10.3 illustrates this outcome. The triangle, labeled R, is the residual loss of $100—the lost surplus that results because it is not efficient to re- solve the incentive problem completely. In addition, the two companies pay $400 each for monitoring and bonding. These payments reduce the surplus by $800, as shown by the rectangle labeled O.14 The remaining surplus is $1,600. This surplus is equal to the original surplus of $2,500 minus the total contracting costs of $900—the sum of the out-of-pocket costs (monitoring and bonding costs) and the residual loss. In the end, Brown & Brown earns a net profit of $800 [� $5,200 � (40 � 100) � 400]. Good Tire obtains net benefits of $800 [� $6,400 � $5,200 � $400].15 Both firms are $450 per week worse off than in the case where there was neither asym- metric information nor incentive problems.
Precontractual Information Problems
Information normally is asymmetric at the time of contract negotiations, as well. For example, in negotiating a labor contract, the prospective employee typically has su- perior information on what wage is acceptable, whereas the employer knows more about what the firm is willing to pay. Precontractual informational asymmetries also generate contracting costs and can cause at least two major problems—bargaining failures and adverse selection.
Bargaining Failures Asymmetric information can prevent parties from reaching an agreement even when in theory a contract could be constructed that would be mutually advantageous. Sup- pose that Sheri Merriman is willing to accept a job for as little as $2,500 per month and Jon Park, the human resources manager, is willing to pay as much as $3,000 per month. In principle, a mutually advantageous contract could be negotiated at any price between $2,500 and $3,000. Neither side, however, is likely to know the other side’s reservation price (the highest price that Jon is willing to offer and the lowest price that Sheri is willing to accept). In an attempt to get the best price possible, both parties might overreach, resulting in a bargaining failure. In her initial interview, Sheri might ask for $3,500. Hearing this, Jon might discontinue negotiations because he doubts that he can hire Sheri for less than $3,000 (his reservation price). This phe- nomenon helps to explain the existence of labor strikes that end up hurting both labor
13Good Tire cannot observe the actual hours worked by Brown & Brown. Nonetheless, it can have rational expectations (an unbiased forecast given the information that it does have) that Brown & Brown will work 40 hours, yet bill for 50. Note that the $5,200 price is chosen somewhat arbitrarily in this example; as we
will see, it is the price that splits the surplus. 14The placement of this rectangle is arbitrary. All that is important is that the area of the original surplus be
reduced by the $800 out-of-pocket expenses. 15The $6,400 is the gross surplus for Good Tire. It is the area under the marginal benefit curve between zero
and 40 hours.
344 Part 2 Managerial Economics
and the company. (Strikes result in lower productivity and sales; thus there are fewer profits to be divided between labor and the company.)
Adverse Selection A second problem caused by precontractual informational asymmetries is adverse selection. Adverse selection refers to the tendency of an individual with private in- formation about something that affects a potential trading partner’s costs or benefits to extend an offer that would be detrimental to the trading partner.
As an example, consider the market for health insurance.16 Table 10.1 displays three individuals and their expected medical costs for the year. Angela is the healthiest and expects to spend only $100 on medical expenses, whereas Cindy is the least healthy and expects to spend $900; Bruno is in the middle with expected expenditures of $500. The average expected expenditure for all three individuals is thus $500 per person.
It is likely that each individual knows more about his or her health than an insur- ance company does: Individuals know how they have been feeling and their health
M A N A G E R I A L A P P L I C AT I O N S
Incentive Problems between Homeowners and Real Estate Agents Real estate agents perform an important economic function in connecting buyers and sellers of homes and in marketing
the listed properties. The typical agent conducts an initial evaluation of the property, takes pictures to use in marketing
materials, helps to set the price, writes ads, shows the house to prospective buyers, negotiates the offers, and sees the
deals through to the end. The typical contract between the seller and the agent pays the agent a commission of 6
percent of the final selling price, which generally is split among agents involved in the sale.
While the sales commission helps to motivate the agent, it does not provide strong incentives for the agent to work
hard to obtain a high price. As an example, suppose that a prospective buyer offers $300,000 to purchase a house and
the opportunity cost of the agent is $2,000 per day. The agent believes that by working an extra day she can obtain a
price of $320,000 for the home. The commission is $18,000 if the house is sold for $300,000 versus $19,200 if the
house sells for $320,000. From the agent’s perspective, it is not worth working a full day to obtain the higher
commission. The $2,000 opportunity cost exceeds the extra $1,200 in commissions, which would likely be shared with
other agents. The seller’s and agent’s incentives are not perfectly aligned.
If the agent owned the house, there would be no incentive conflict. The agent would have strong incentives to work
an extra day to obtain a $20,000 higher price, since it would far exceed the opportunity cost of working to obtain it. A
recent study of the sale of nearly 100,000 home sales in suburban Chicago identifies over 3,000 houses sold that were
owned by agents. Using the data from the sales of those 100,000 Chicago homes, and controlling for other important
variables—location, age and quality of the house, aesthetics, whether or not the property was an investment, and so
on—it turns out that real-estate agents keep their own homes on the market for an average of 10 days longer and sell it
for an extra 3-plus percent, or about $10,000 on a $300,000 house. When agents sell their own house, they hold out and
work for a higher offer; in contrast, when they are acting as an agent, they encourage the sellers to take the first decent
offer that comes along. While homeowners often benefit from holding out for a higher selling price, the agents want to
make deals and make them fast. Why not? Their share of the 6 percent commission provides too puny of an incentive
to encourage them to do otherwise. Homeowners potentially benefit if they understand these incentives and do not act
blindly in accepting whatever advice an agent has to offer.
Source: S. Levitt and S. Dubner (2009), Freakonomics: A Rogue Economist Explores the Hidden Side of Everything (Harper Perennial): New York.
16Managers often are involved in designing or modifying fringe-benefit policies. Understanding the following
problem is important in this activity. We discuss this issue in greater detail in Chapter 11.
Chapter 10 Incentive Conflicts and Contracts 345
habits, whereas an insurance company is likely to have information that is restricted to the typical expenditures for readily observed categories within the population (e.g., age and gender categories). In this spirit, suppose that each individual knows his or her expected expenditure whereas the insurance company knows only the ex- pected expenditure for the three individuals as a group—$500 per person. If the com- pany expects to make a profit, it must sell insurance policies at premiums that exceed the expected expenditures of the buyers.
The information structure in this example can dissuade some potential customers from transacting in the market, thereby reducing the gains from trade. For instance, assume that the insurance company tries to sell insurance at $510. If all three parties were to buy the insurance, the company would expect to make a profit. However, at this price, Angela might not want to purchase insurance. She expects to spend only $100 on medical expenses; from her perspective, the insurance appears extremely expensive.17 At a premium of $510, if only Bruno and Cindy bought the insurance, the company on average would lose money: Expected losses would be $190 per pol- icyholder since their expected expenses would be $700. The insurance company might anticipate that healthy individuals will not buy the insurance at $510 and quote a higher price. For example, if the insurer offered the policies to both Cindy and Bruno and they purchased at $710, it would make a profit. However, at this price Bruno is less likely to buy the insurance because the price is substantially above his expected expenditure of $500. In the end, the insurance company might price insur- ance at a cost above $900 and sell only to Cindy—the least healthy of the three.
The company might be able to sell insurance to all three parties by becoming bet- ter informed about the individual health status of each of its applicants so that it could quote more customized rates. For example, it might require a medical exam of all applicants, as well as access to their medical records. In this case, different rates could be charged, depending on the health of the individual. Collecting information, however, is costly, and thus there is an incentive to consider these costs in the design of the
17Since Angela is risk-averse, she would be willing to spend more than $100 for insurance (see Chapter 2).
However, here we assume that she concludes that $510 is too expensive.
Expected Annual Medical Expenditure
Angela Wilson $100 Bruno Lopez $500 Cindy Lo $900
All three individuals $500 per person
Table 10.1 Example of Adverse Selection in Insurance Markets
This table shows the expected annual medical expenditures for three individuals. If an insurance company sells insurance to all three at a price above $500 per year, it expects to make a profit. However, if the company prices insurance at $500, Angela is unlikely to purchase the insurance. Bruno and Cindy have average expected expenditures of $700 per person. Thus, if Bruno and Cindy are the sole purchasers, the company must sell the insurance at above $700 to break even. In this case, Bruno might not buy the insurance. The end result can be a market failure, where the company prices the insurance at $900 and sells only to Cindy.
346 Part 2 Managerial Economics
organization and its policies.18 For instance, since the cost of the additional informa- tion is fixed, the insurer might require exams of applicants requesting broader cov- erage limits but not for those willing to accept narrower coverage.
In some cases, adverse-selection problems can be reduced by the clever design of contracts. An insurance company might be able to offer a menu of contracts with dif- ferent deductibles, coinsurance requirements, and prices that would motivate these individuals to self-select based on their private information. For example, Angela might choose a low-priced insurance contract with a high deductible, whereas Cindy might choose a high-priced contract that provides full insurance. In this case, the company might be able to sell insurance to all three customers at a profit.
Sometimes, it is possible for individuals to communicate, or signal, their private information to other parties in a credible fashion. For example, Angela might be able to convince the insurance company that she is quite healthy and should be of- fered insurance at a low rate. (She might document that she participated in six marathon races during the year.) Angela’s communication to the company will be convincing to the company only if the cost to Bruno and Cindy for sending the same signal is higher than Angela’s (e.g., because they are not in excellent health, they are unable to participate in marathons). Otherwise, they could take the same action to claim they were healthy, and then there would be no reason for the com- pany to believe any of their claims.
18The company also might overcome the problem by selling group insurance to a company that employs all
three individuals. In this case, the individuals do not select whether or not to be covered. Thus, the insurance
company can make a profit at a premium above $500 per person. Note that insurance regulations vary across
countries. The Affordable Care Act (ACA) enacted in 2010, currently requires insurance companies in the United States to offer the same rates for health insurance regardless of preexisting conditions or sex. These
restrictions potentially make it more costly for U.S. insurance companies to address adverse selection
problems. The ACA requires all individuals who are not otherwise covered to purchase private coverage or
pay a penalty. The intent of this provision is to reduce the adverse selection problem. It remains in question
as to whether this will be effective, given that many of the young and healthy may choose to pay the penalty,
rather than to purchase what for them are overpriced policies.
M A N A G E R I A L A P P L I C AT I O N S
Rising Health Care Costs Create Employee Conflicts As health care costs rise, many employers are passing on these costs to their employees who are paying a larger
fraction of the total health insurance premium. Since at most companies, 80 percent of the health care costs are
generated by 20 percent of the employees, healthy workers resent having to pay more to finance the unhealthy habits of
a few. David Jackson who works at Rockford Products Corp. points to a coworker driving a forklift truck. “Just look at
that guy, his belly’s almost touching the steering wheel. It’s gross.” The forklift driver weighs 340 pounds and has
trouble walking because of pain in his ankles due to his weight. Because workers are bearing more of their health
insurance costs, workers are starting to pay attention to their colleagues’ eating and smoking behavior. Young workers
are questioning how much they should pay for seniors, or why employees with one or two children should pay for
employees with large families. While such behavior induced by increasing the percentage of health insurance paid by
the employees is creating friction within companies, such peer pressure might actually lead to a healthier workforce.
Source: T. Aepel (2003), “Skyrocketing Health Costs Start to Pit Worker vs. Worker,” The Wall Street Journal (June 17), A1, A6.
Chapter 10 Incentive Conflicts and Contracts 347
Adverse-selection problems are not limited to insurance markets; they occur in many settings. Prospective employees are likely to know more about their talents and productivity than employers. Similarly, the seller of a used car knows more about the quality of the car than the buyer. Thus, at a given price, sellers are more likely to offer “lemons” than high-quality cars.19 In these settings, traders often develop mecha- nisms that help reduce adverse-selection problems. Used-car dealers offer warranties that guarantee that if the car is a lemon, the dealer will repair or exchange it at the dealer’s expense. Also, there are diagnostic mechanics that provide prospective buy- ers with a professional assessment of the quality of a car.
Implicit Contracts and Reputational Concerns
Implicit Contracts Many of the contracts that constitute the firm are implicit: They consist of promises and understandings that are not formalized within legal documents. Examples in- clude promises of promotions and salary increases for a job well done and informal understandings that suppliers will not shirk on quality. By definition, implicit con- tracts are difficult to enforce in court; they depend largely on private incentives of in- dividuals to honor their terms. Given the incentive conflicts that we discuss in this chapter, why would individuals ever expect others to honor terms of implicit con- tracts? Specifically, why would an employee ever trust an unwritten promise by a manager to give the employee a raise for a job done well? Doesn’t the manager al- ways have incentives to abrogate the contract after the job is complete? After the task is complete, the benefits are sunk. Not granting the raise would appear to reduce costs, increase profits, and thereby increase the manager’s bonus.
19G. Akerlof (1970), “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84, 488–500.
M A N A G E R I A L A P P L I C AT I O N S
Fraud in Small Firms The nightly news often features stories about fraud and other scandals in large corporations. Fraud and other incentive
conflicts, however, are not just large firm problems. They can and do occur in firms of all size.
In 2014, the office manager of a Florida medical office, Heart Care Centers of Central Florida, was arrested for
embezzlement. According to the county sheriff, she had embezzled more than $650,000 over a two-year period, using
the money to rent an upscale home, buy furniture, electronics, a 2014 Audi Q7, and an S7. She was booked on 128
felony charges, including money laundering, fraudulent use of a credit card, and forgery. According to reports,
She transferred money from the medical group to her companies … opened credit cards and lines of credit, some under the medical group's name, some under doctors' name.
The global losses of companies due to employee fraud are estimated to be $3.7 trillion annually. Small companies are
among the most common victims. Fraud occurs in all regions throughout the world. While it is not practical to
eliminate all possibilities of fraud, the problem can be reduced by various practices, such as requiring all employees in
financial positions to take periodic vacations (where their functions are performed by other employees) and periodic
review or audits of the accounts.
Source: A. Ford (2014), “BCSO: Titusville medical office manager embezzled thousands’” Florida Today (May 1).
348 Part 2 Managerial Economics
Reputational Concerns The answer to these questions is that reputational concerns act as a powerful force to motivate contract compliance. In particular, the market can impose substantial costs on institutions and individuals for unscrupulous behavior. Thus, market forces can provide powerful private incentives to act with integrity. (Chapter 22 contains an ex- tended discussion on promoting ethical behavior within corporations.)
As an example, consider a firm that has a long-term contract to provide a metal part to a manufacturing firm each month at a price of $10,000. The cost of produc- ing this product is $9,000, so the profit per unit is $1,000. It is possible for the sup- plier to produce a low-quality product for $2,000. However, it has agreed to provide a high-quality product. Suppose the quality of the part is known to the buyer only after the purchase; it would be possible for the supplier to make a profit of $8,000 by producing a low-quality part, yet claiming it to be high-quality. The buying firm, however, will detect the quality of the part after purchase and will cancel future pur- chases if it is cheated. The supplying firm thus faces a trade-off. It can gain an ad- ditional $7,000 in the short run by cheating. However, it loses a $1,000 per month future profit stream. The supplier has a strong incentive to be honest so long as the present value of the future profit stream is greater than the short-run gain from cheating.
Typically, the costs of cheating on quality are higher if the information about such activities is more rapidly and widely distributed to potential future customers. Within a market like the diamond trade in New York, misrepresenting quality to another mer- chant is quite rare. This market is dominated by a close-knit community of Hasidic Jews; information about dishonest behavior spreads rapidly throughout this market. In other broader markets, specialized services that monitor the market help ensure
M A N A G E R I A L A P P L I C AT I O N S
Sony’s Implicit Contract Sony Corporation has a valuable brand name and an implicit contract with customers for providing consistent high-
quality products and services. Violations of this implicit contract are likely to diminish customers’ trust in the company
and reduce the value of the Sony brand name.
In 2011, hackers infiltrated the Sony PlayStation network and stole data on more than 77 million users. Just a few
days later, the hackers struck again by infiltrating an older database, containing sensitive customer information
including names, addresses, birth dates, passwords, and even credit card information. The public announcement of
these actions raised significant concerns among Sony customers and was arguably viewed as a violation of the implicit
agreement to provide high-quality services.
It took Sony about one month to restore its system. Afterward, Sony offered its customers a welcome-back program
that included upgrades and purchase credits. Sony also offered to enroll customers in identity theft protection programs
at no cost to the customers. In a welcome-back video, Sony executive Kazuo Hirai offered his “sincere apologies for
the inconvenience the service outage has caused.” He went on to say
We know you’ve invested in Sony and the PlayStation network and Qriocity services, and we will do everything we can to regain your trust and confidence. We also realize that actions speak louder than words, and we’re taking aggressive action to address the concerns that were raised by this incident.
Corporate violations of implicit contracts occur from time to time—sometimes inadvertently. In some cases, customer
trust can be restored by appropriate managerial responses. Repeated violations, however, can destroy significant value.
Source: M. Williams (2011), “PlayStation Network Hack Timeline,” IDG News Service (May 1).
Chapter 10 Incentive Conflicts and Contracts 349
contract performance. Consumer Reports evaluates products from toasters to automo- biles, the Investment Dealer’s Digest reports on investment bankers, and Business- Week ranks MBA programs. By lowering the costs for potential customers to deter- mine quality, these information sources increase the costs of cheating.
More generally, reputational concerns are more likely to be effective in promoting contract compliance when (1) the gains from cheating are smaller, (2) the likelihood of detecting cheating is higher, and (3) the expected sanctions imposed if cheating is detected are higher. (For instance, sanctions are likely to be higher if the relationship is anticipated to extend over a longer period.) When these conditions are not met, reputational concerns are less effective in motivating contract compliance. In many settings, reputational concerns are extraordinarily important in promoting coopera- tion and integrity. The ability to enter into self-enforcing agreements can reduce the costs of contracting within an organization materially: Fewer resources are used for negotiating and enforcing formal contracts.
Incentives to Economize on Contracting Costs It is important to understand that everyone has incentives to resolve contracting problems in the least costly manner. By so doing, there are additional gains from trade to share among the parties. In the Good Tire example, if their incentive prob-
lems could be resolved costlessly, there would be an additional $900 of surplus to split between Good Tire and Brown & Brown. (If they didn’t have to spend money on auditors and compliance, they could divide the resulting savings between themselves.)
It is in the self-interest of individuals to minimize total contracting costs in any relationship.20 Incentives exist to negotiate contracts that provide monitoring and bonding activities to the point where their marginal cost equals the marginal gain from reducing the residual loss. This means that incentives exist within the contracting process to produce an efficient utilization of resources (at least from the standpoint of the contracting parties).
Viewing contracts as efficient responses to the particular contracting problem can be an extremely powerful tool in explaining observed organizational architectures. As a simple example, consider the difference between the way fruit pickers are paid and the way employees who assemble airplanes are paid. Agricultural workers usu- ally are paid on a piecework basis: The more fruit they pick, the more pay they re- ceive. Alternatively, employees who assemble airplanes often are paid a straight salary (the same salary is paid independent of output). What accounts for this differ- ence in observed contracts? In general, output increases if people are paid on a piece- work basis. A person will pick more pieces of fruit per hour if paid by the piece than by the hour. However, piecework payments generate their own set of incentive prob- lems. These payments motivate people to focus more on output and less on quality. In fruit picking, a supervisor can monitor the quality of the output inexpensively
20Technical note: For this statement to be strictly true, production costs must be separable from agency costs
and there must be no wealth effects. (The choices of the principal and agent are independent of their
individual wealth levels.) When these conditions are violated, the individuals might not want to minimize
total agency costs. Nonetheless, they still have strong incentives to consider these costs in designing
contracts. For our purpose, it is reasonable and convenient to ignore these technical considerations.
Basic Principle: Value Maximization Incentive problems generate costs that reduce value. It is in the interests of all parties to a contract to develop efficient solutions to agency problems. More value is created, which can be shared among the contracting parties.
350 Part 2 Managerial Economics
through direct inspection of the harvested fruit. In the case of airplanes, quality prob- lems may not be detected until after the employee leaves the job (e.g., after the plane is delivered, put into service, and—in the most extreme case—crashes). In this situ- ation, the contracting costs of piecework payments are larger than the benefits. We apply this type of logic throughout the remainder of this book to explain the design of organizations.
Summary Treating a firm as if it were an individual decision maker who maximizes profits is a useful abstraction in some contexts. For example, this characterization has been used in previous chapters in analyzing output and pricing decisions. But to analyze orga- nizational issues within the firm requires a richer definition. A particularly useful de- finition for our purposes is that the firm is a focal point for a set of contracts.
ANALYZING MANAGERIAL DECISIONS: eBay.com*
eBay operates the world’s largest online auction. In
early 2008, eBay operated in 39 counties with 276
million registered users worldwide. The total value
of all successfully closed items in 2007 was $59 bil-
lion with an average of $2,039 worth of goods trad-
ing on the site every second. Sellers pay a small fee
to eBay to list their items. They provide a description
of the item, photographs, the minimum acceptable
bid, accepted forms of payment, and other relevant
information. Items can be sold at a fixed price or
through an auction. In an auction, bidders submit
electronic bids over the Internet. After the auction
closes (auctions usually last several days), the high
bidder receives an e-mail. The high bidder must con-
tact the seller within three business days to claim the
item and arrange payment and delivery. eBay pro-
vides other support services:
• The Feedback Forum is a place where eBay users leave comments about each other’s buy-
ing and selling experiences. If you are a bid-
der, you can check the seller’s Feedback Pro-
file easily before you place a bid to learn
about the other buyers’ experience. If you’re a
seller, you can do the same thing to check out
buyers. Each participant is given a Feedback
Score based on the number of positive and
negative ratings that they have received. Par-
ticipants with sufficient positive ratings are
flagged by colored stars. The highest rating is
the “Red shooting star.” eBay has created a set
of policies to guard against “feedback manip-
ulation” and “feedback abuse.”
• eBay users are encouraged to settle transac-
tions through PayPal. PayPal provides free insurance of up to $2,000 on some items to
protect buyers in cases where they do not re-
ceive the item or it was less than expected.
• Participants sign user agreements that specify
the trading rules and expectations. eBay’s
safety staff investigates alleged misuses at
eBay such as fraud, trading offenses, and ille-
gally listed items. Potential resolutions include
such things as banning a person from future
trading on eBay.
1. How does eBay create value?
2. What potential contracting problems exist on
eBay?
3. How does eBay address these problems?
4. What are the contracting costs at eBay?
5. eBay claims that it has only a small problem
with fraud and misuse of the system. Does
this imply that it is overinvesting in addressing
potential contracting problems? Underinvest-
ing? Explain.
*To obtain more detailed information, go to www.ebay.com.
Chapter 10 Incentive Conflicts and Contracts 351
Since individuals are creative maximizers of their own well-being, there are likely to be incentive conflicts among the parties that contract with the firm. Examples in- clude owner-manager, buyer-supplier, and free-rider conflicts. Contracts (explicit and implicit) specify a firm’s organizational architecture (its decision right, performance evaluation, and reward systems). This architecture establishes a set of constraints and incentives that can reduce the costs of incentive conflicts. Contracts are unlikely to re- solve incentive problems completely because they are costly to negotiate, administer, and enforce. Asymmetric information causes particularly important problems.
An agency relationship consists of an agreement under which one party, the principal, engages another party, the agent, to perform some service on behalf of the principal. Many agency relationships exist within firms. Agents do not act in the best interests of principals automatically—there are incentive problems.
Asymmetric information usually implies that incentive problems cannot be re- solved costlessly by contracts. The principal usually can limit the divergence of in- terests by structuring the contract to establish appropriate incentives for the agent and by incurring monitoring costs aimed at limiting dysfunctional activities by the agent. Also, agents might incur bonding costs to help guarantee that they will not take certain actions or to ensure that the principal will be compensated if they do. Generally, it does not pay to resolve incentive conflicts completely. The dollar equivalent of the loss in the gains from trade that results due to the divergence of interests in the agency relationship is known as the residual loss. Total agency costs are the sum of the out-of-pocket costs (monitoring and bonding costs) and the opportunity cost of the residual loss.
Precontractual informational asymmetries can cause breakdowns in bargaining and adverse selection. Adverse selection refers to the tendency of individuals, with private information about something that affects a potential trading partner’s costs or benefits, to make offers that are detrimental to the trading partner. Costs of adverse selection reduce the gains from trade and can cause market failures. Precontractual information problems can be mitigated by information collection, clever contract de- sign, credible communication, and mechanisms such as warranties.
Many of the contracts within firms are implicit contracts rather than formal legal documents. Implicit contracts are difficult to enforce in a court of law and depend largely on the private incentives of individuals for enforcement. Reputational con- cerns can provide incentives to honor implicit contracts. These concerns are more likely to be effective when (1) the gains from cheating are smaller, (2) the likelihood of detecting cheating is higher, and (3) the expected sanctions imposed if cheating is detected are higher. It sometimes is possible to structure organizations in ways that increase the likelihood that reputational concerns will be more effective in encour- aging individuals to behave with integrity.
Parties to a contract have incentives to resolve contracting problems in the least costly manner. By so doing, there are additional gains from trade to share among the parties. Viewing observed contracts as efficient responses to the particular contract- ing problem provides a powerful tool for explaining organizational architecture.
O. Hart (1989), “An Economist’s Perspective on the Theory of the Firm,” Columbia Law Review 89, 1757–1774.
M. Jensen and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure,” Journal of Financial Economics 3, 305–360. Pay particular attention to the first 11 pages.
Suggested Readings
352 Part 2 Managerial Economics
M. Jensen and C. Smith (1985), “Stockholder, Manager, and Creditor Interests: Applications of
Agency Theory,” in E. Altman and M. Subrahmanyam (Eds.), Recent Advances in Corporate Fi- nance (Richard D. Irwin: Burr Ridge), 93–131.
J. McMillian (1992), Games, Strategies, and Managers (Oxford University Press: New York).
G. Miller (1992), Managerial Dilemmas: The Political Economy of Hierarchy (Cambridge Univer- sity Press: Cambridge).
10–1. John owns a home construction company. His cost for building a new house is $300,000. Sue is a potential home buyer who would be willing to pay John up to $400,000 to con-
struct a new house if she knew for certain that John would not cheat her (e.g., using below
standard, less expensive building materials in constructing the house).
a. Suppose that Sue does not buy the house because she decides there is no way to prevent John from cheating her. What are the total agency costs? Divide these costs into the residual loss and out-of-pocket costs.
b. Suppose that Sue hires an engineer for a cost of $20,000 to monitor the construction process. Sue expects that the engineer’s work will significantly decrease the likelihood
that John will cheat on the contract. There, however, is still some chance that John will
cheat. Because of this possibility, Sue values the house at $390,000 rather than
$400,000. Given her $20,000 expenditure for the engineer, her maximum willingness to
pay is $370,000. Suppose that Sue pays John $350,000 to construct the house. What are
the total gains from trade and how are they split? What are the total agency costs? 21 Di- vide these costs into the residual loss and out-of-pocket costs.
c. Suppose that an additional engineer could be hired at a cost of $20,000 that would re- duce the probability of John’s cheating to zero. Would it be in Sue and John’s joint in-
terest to hire the engineer? Explain.
d. Why should Sue pay for the engineer? Isn’t it John’s responsibility to assure that he will comply with the contract?
10–2. Suppose that a health insurance company is considering offering insurance to a population consisting of healthy and unhealthy people. Healthy people are expected to have $1,000 per
year in medical bills, while unhealthy people are expected to have bills of $5,000 per year.
The company knows that the population consists of 25,000 healthy people and 25,000 un-
healthy people. However, it cannot tell whether any given individual is healthy or unhealthy.
Individuals know their own type and only purchase insurance if the premium is no more
than $100 above their expected medical bills. The insurance must be priced at least $100
above expected per-person costs for the insurance company to cover its costs and to be prof-
itable. In equilibrium, what price will the insurance charge in this market? Who will buy the
insurance? Assume for this problem that there are no binding regulations that limit insur-
ance prices or force people to purchase insurance.
Solutions to Self-Evaluation Problems 10–1. Postcontractual Information Problems and Agency Costs
a. The potential gains from trade of $100,000 equal the difference between Sue’s reserva- tion price for the house and John’s cost of building the house: $400,000 � $300,000 � $100,000. These gains from trade are lost when Sue doesn’t transact because of the
incentive problem. Therefore, the total agency costs are $100,000. There are no out-of-
pocket expenses. The $100,000 is a residual loss.
Self-Evaluation Problems
21John’s reduction in building costs if he cheats could produce a private benefit that should be included in the
calculation of the gains from trade and agency costs. However, John is also likely to face costs if he cheats
(e.g., lost reputation if he is caught) that would reduce the net benefits. For simplicity, assume that John’s
net benefit from cheating is zero after the hiring of the engineer (this would make him indifferent between
cheating and not cheating). With this assumption, John’s cost is $300,000 whether he cheats or not.
Chapter 10 Incentive Conflicts and Contracts 353
b. The total gains from trade are $65,000: $385,000 (Sue’s valuation) � $20,000 (for the engineer) � $300,000 (John’s costs) � $65,000. The total gains from trade of $65,000 are split as follows. Sue gets $15,000: $385,000 (her value for the house) � $20,000 (the cost of the engineer) � $350,000 (price of the house) � $15,000; John gets $50,000: $350,000 � $300,000 � $50,000. The total agency costs of $35,000 equal the difference between the potential gains from trade with zero contracting costs and the ac-
tual gains from trade given costly contracting: $100,000 (see part a) � $65,000 � $35,000. These costs are divided into out-of-pocket costs and the residual loss. The out-
of-pocket costs are $20,000 for the engineer. The residual loss is the remaining $15,000:
$35,000 (total agency costs) � $20,000 (out-of-pocket costs) � $15,000. This residual loss reflects the fact that due to the agency problem Sue gets a house that she values at
$385,000 instead of $400,000.
c. It would not be in Sue and John’s interest to hire another engineer. Hiring the additional engineer costs $20,000, while elimination of the remaining residual loss is worth only
$15,000. Thus, the gains from trade would fall by $5,000 if they hired the extra engi-
neer. [The gains would equal: $400,000 (Sue’s value) � $300,000 (John’s costs) � $40,000 (cost of the engineers) � $60,000, which is $5,000 lower than when only one engineer is hired.]
d. Paying for the engineer is a value-increasing expenditure that reduces total agency costs and increases the gains from trade. It is in the joint interests of John and Sue to hire the
engineer since it increases their gains from trade. It is not important who writes the
check to cover this expense. How the gains from trade are split is ultimately determined
by the transaction price. For example, the same split would occur if John wrote the
$20,000 check for the engineer, and Sue paid $370,000 for the house. [In some transac-
tions, the gains from trade can depend on who writes the check, for example if one
party can deduct the expense for tax purposes, while the other cannot.]
10–2. Precontract Information Problems: Adverse Selection
The equilibrium price is $5,100 and only unhealthy people will buy the insurance. The
following explains why. If all 50,000 people bought the insurance, the company would
expect to earn $100 per customer if it priced the insurance at $3,100. It would expect to
lose $1,900 on each of the unhealthy people and make $2,100 on each of the healthy peo-
ple. Given that there is a .5 probability that any given person is healthy, it would expect to
make [(.5 � $2,100) � (.5 � $1,900)] � $100 per person (the necessary amount to stay in business). There, however, is adverse selection at the $3,100 price—people who know that they are healthy will not buy the insurance. Since only unhealthy people buy the in-
surance at $3,100, the company would expect to lose $1,900 per customer. The company,
therefore, prices the insurance at $5,100 and only sells to people who know they are un-
healthy. The company cannot charge more than $5,100 because no one will buy the insur-
ance. If it charges less it will not make the necessary $100 per customer to stay in busi-
ness. Potential gains from trade in selling insurance to healthy people are lost unless the
company can devise a way to address the adverse selection problem.
10–1. What is a firm?
10–2. Give examples of incentive conflicts: a. Between shareholders and managers b. Between coworkers on teams
10–3. What is asymmetric information? How can it limit contracts from solving incentive con- flicts?
10–4. Name the two parties involved in an agency relationship.
10–5. What potential problems exist in agency relationships?
10–6. Is it worthwhile for shareholders to seek to completely eliminate incentive problems with managers and directors through means such as monitoring? Why or why not?
Review Questions
354 Part 2 Managerial Economics
10–7. What is adverse selection? Give an example.
10–8. How do reputational concerns aid in the enforcement of contracts?
10–9. Schmidt Brewing Company is family-owned and -operated. The family wants to raise some capital by selling 30 percent of the common stock to outside shareholders. The com-
pany has been profitable, and the family indicates that it expects to pay high dividends to
shareholders. The family will maintain 70 percent ownership of the common stock and
continue to manage the firm. The rights of shareholders are specified in the company’s
corporate charter. The charter specifies such items as voting rights (procedures and items
subject to a vote), meeting requirements, board size, rights to cash flows, and so on. Once
adopted, a charter can only be changed by a vote of the shareholders. What types of provi-
sions in the corporate charter of Schmidt Brewing might motivate minority shareholders to
pay higher prices for the stock? Explain.
10–10. Which of the following examples is an adverse-selection problem and which is an incen- tive problem? Explain why. In each case, give one method that the restaurant might use to
reduce the problem.
a. A restaurant decides to offer an all-you-can-eat buffet that is sold for a fixed price. The restaurant discovers that the customers for this buffet are not its usual clientele.
Instead, the customers tend to have big appetites. The restaurant loses money on the
buffet.
b. A restaurant owner hires a manager who promises to work long hours. When the owner is out of town, the manager goes home early. This action results in lost profits
for the firm.
10–11. In 1992, the state of California charged Sears Auto Centers with overcharging customers for unneeded or unperformed repairs. Sears agreed to a settlement that could cost as much
as $20 million. Sears had compensated its salespeople with commissions based on total
sales. Following the settlement, Sears dropped the commissions and went to a straight
salary. Sears recently indicated that it is planning to reinstate commissions for salespeople
in their Auto Centers. It even plans on paying commissions for selling customers brake
jobs and wheel alignments. These two products were the core of the 1992 scandal. Sears
says that it has taken steps to prevent a recurrence of past problems. In particular, the deci-
sion right to recommend repairs is granted to mechanics who are paid a straight salary.
Sales consultants are paid commissions for selling repair services but are not authorized to
recommend repairs. Under the old system that caused problems, these individuals diag-
nosed repair problems and sold the corresponding service to customers. Why do you think
Sears wants to reinstall commissions for its salespeople? Do you think that the new safe-
guard that separates diagnosing problems from selling services will prevent a recurrence
of past problems? Explain.
10–12. The Sonjan company currently purchases health insurance for all of its 1,000 employees. The company is considering adopting a flexible plan whereby employees can either have
$2,000 in cash or purchase an insurance policy (which currently costs $1,000). Do you see
any potential problems with the new plan? Explain.
chapter
11 C H A P T E R O U T L I N E
The Fundamental Problem
Architecture of Markets
Architecture within Firms
Architectural Determinants
Changing Architecture
Interdependencies and Complementarities within the Organization
Corporate Culture
When Management Chooses an Inappropriate Architecture
Managerial Implications
Evaluating Management Advice
Benchmarking
Summary
F ounded in 1919, Brabantia is one of Europe’s largest manufacturers of household products such as ironing boards, waste bins, food storage canisters, kitchen tools, and mailboxes. Headquartered in the Netherlands with 1,000 employees and 2013 sales of about
$150 million, the company specializes in steel and stainless steel utensils. Through the 1980s and 1990s Brabantia faced increased competition for its products. With the creation of a “single market” within the European Economic Union, other European companies entered Brabantia’s local mar- kets. As Europe’s population growth slowed, the household utensil market became saturated. And large, mass-marketing retailers entered the European market driving out many of Brabantia’s traditional outlets—small house- hold specialty stores.1
Brabantia required new products and new channels of distribution. It had to become more efficient. It had high rates of rework and scrap, low levels of productivity, and high rates of employee absenteeism. The firm was organized quite centrally with traditional formal hierarchies, task special- ization, and a functional structure. New products and programs were “top down” in nature and usually excluded input from lower-level operational staff. The firm assessed its performance based on cost, margins, and meet- ing output goals—not on measuring quality or customer satisfaction. Pay in- creases were based on seniority and companywide pay settlements.
Organizational Architecture
L E A R N I N G O B J E C T I V E S
1. Describe the fundamental problem facing all organizations and how the architec- ture of markets differ from the architecture of firms.
2. List the three components of a firm’s organizational architecture. 3. Explain how a firm’s business environment and strategy help to determine its
optimal organizational architecture.
4. Describe how the three components of an organization’s architecture are interre- lated and why it is important to design them in a balanced (complementary)
fashion.
5. Describe the role of corporate culture and its connection to organizational architecture.
6. Understand why, how, and when firms change their organizational architecture.
P A R T T H R E E D e s i g n i n g O r g a n i z a t i o n a l A r c h i t e c t u r e
1Source: “New Forms of Work Organization: Case Studies,” European Commission, Directorate-
General for Employment, Industrial Relations and Social Affairs, Unit V/D.3 (June 1998); and
www.Brabantia.com.
356 Part 3 Designing Organizational Architecture
To address its problems of increased competition, shrinking channels of distribu- tion, low worker productivity, and a stale product line, Brabantia instituted a series of organizational changes that were designed to enhance performance. These changes involved three important aspects of the organization that we refer to as the firm’s organizational architecture:2
• The assignment of decision rights within the firm
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals and business units
Senior managers set the overall policies of the firm, including its organizational architecture. One change involved giving lower-level managers greater control over their work and substantial authority to make and implement decisions. Semiau- tonomous work teams were given considerable freedom in ordering raw materials, scheduling production, and recruiting new team members. All employees partici- pated in writing a new mission statement that emphasized Brabantia’s unique prod- uct designs and their usability. In other words, Brabantia decentralized the assign- ment of decision rights within the organization.
The company began to focus on innovation, new product development, rather than cost or output. It changed how employees were rewarded, placing greater emphasis on rewarding teams and individuals. It also restructured its information systems to moni- tor performance using a broader range of objectives, such as quality and customer sat- isfaction. Employees were trained to work in groups and to apply continuous improve- ment techniques with an emphasis on staff involvement. Formal policy statements were drafted to explain the new organizational architecture and mission statement to all employees.
The results have been impressive. The time to develop new products was reduced 20 percent. Quality and productivity have improved. Scrap and rework rates have fallen. And, employee satisfaction has improved.
This example of Brabantia illustrates that organizational architecture is an impor- tant determinant of the success or failure of firms. The purpose of this chapter is to introduce the concept of organizational architecture and to provide a broad overview of the factors that are likely to be important in designing the optimal architecture for a particular organization.
Understanding organizational architecture provides managers with powerful tools for affecting their firm’s performance. As we shall see, managers must be careful and thoughtful in their use of these tools or the results can be counterproductive. This book presents material designed to help managers employ these tools more effectively.
We begin by discussing the fundamental problem facing firms and markets. We then examine how organizational architecture can help resolve this problem.3
2The importance of these three features of organizations has been recognized by a number of authors in
economics and management. For instance, see M. Jensen and W. Meckling (1995), “Specific and General
Knowledge, and Organizational Structure,” Journal of Applied Corporate Finance 8:2, 4–18; P. Milgrom and J. Roberts (1992), Economics, Organization & Management (Prentice Hall: Englewood Cliffs); and D. Robey (1991), Designing Organizations (Richard D. Irwin: Burr Ridge).
3The first part of this chapter draws on M. Jensen and W. Meckling (1992), “Specific and General Knowledge,
and Organizational Structure,” Journal of Applied Corporate Finance 8:2, 4–18.
Chapter 11 Organizational Architecture 357
The Fundamental Problem The primary goal of any economic organization is to produce the output customers want at the lowest possible cost. The challenge of discovering customer demands while reducing costs, both for economic systems and within individual firms, is com- plicated by the fact that important information for economic decision making gener- ally is held by many different individuals. Furthermore, this information often is quite expensive to transfer (e.g., the information is specific as opposed to general ). For example, a scientist is likely to know more about the potential of a specific re- search project than are executives higher in the firm. Similarly, individual machine operators normally know more about how to use their particular machines than do their supervisors. In both cases, communicating such information to headquarters for approval prior to acting on the information is likely to be cumbersome, resulting in many lost opportunities.
A second complication is that decision makers might not have appropriate incen- tives to make more effective decisions even if they have the relevant information. There are incentive problems. For example, a scientist might want to complete a research project out of scholarly interest, even if convinced the project is unprof- itable. Similarly, machine operators might not want to use machines efficiently if this would mean additional work for them.
In sum, the principal challenge in designing firms (as well as entire economic sys- tems) is to maximize the likelihood that decision makers have both the relevant infor- mation to make good decisions and the incentives to use the information productively.
There are many alternative ways of organizing economic activity to try to achieve these objectives. Economic transactions can occur within markets or firms. Firms can be organized as corporations, mutuals, partnerships, supplier cooperatives, employee-owned companies, or sole proprietorships. In each case, there are many different possible organizational architectures. All these alternatives involve costs as well as benefits. As we have discussed in previous chapters, individuals have incen- tives to select value-maximizing forms of organization. By maximizing the “size of the pie,” there is more value to share among the parties to the transaction. To achieve this objective, it is important to have a detailed understanding of the architectures of both markets and firms.
Architecture of Markets
The price system helps resolve information and incentive problems in markets. In market economies, individuals have private property rights. If Jorge Ortega owns a building, he decides how it will be used. If Aldo Deng knows how to make better use of the building, Aldo can bid more for the building than it is worth to Jorge. Jorge can sell it and pocket the proceeds. Aldo has strong incentives to use the building produc- tively because he bears the wealth effects.
Hence, the market provides an architecture that promotes efficient resource use. First, through market transactions, decision rights for resources are rearranged so that they tend to be held by individuals with the relevant specific knowledge for using those resources most productively. Individuals with the relevant specific knowledge will profit the most by owning the resources and thus are likely to be will- ing to pay a higher price to own them. Second, the market provides a mechanism for evaluating and rewarding the performance of resource owners: Owners bear the
358 Part 3 Designing Organizational Architecture
wealth effects of their actions. This mechanism generates important incentives to take efficient actions—actions for which benefits exceed costs. A valuable feature of the price system in a market economy is that this architecture is created sponta- neously, requiring little conscious thought or human direction.
Architecture within Firms
Within firms, there are no automatic systems either for assigning decision rights to individuals with information or for motivating individuals to use information to pro- mote a firm’s objectives. Organizational architecture is created by executives through the implicit and explicit contracts that constitute the firm (see Chapter 10). For instance, decision rights are granted to employees through formal and informal job descriptions, whereas performance evaluations and rewards are specified in for- mal and informal compensation contracts. At Brabantia, both the old and new archi- tectures were designed and implemented by senior management.
Decision Rights Although transfer prices are used to allocate selected resources in some firms, most resources are allocated by administrative decisions.4 For example, the CEO of a company typically transfers a manager from one division of the company to another by a simple command. Similarly, the utilization of a plant can be changed by admin- istrative order. A critical responsibility of senior management is to decide how to as- sign decision rights among employees of the firm.5 For instance, does the CEO make most major decisions, or are these decisions delegated to lower-level managers? Can machine operators deviate from procedures outlined in company manuals?
One interesting feature of markets is how they often arise with limited human direction. As an example, economist R.
A. Radford studied economic activity inside prisoner-of-war camps during World War II. In these camps, prisoners
obtained rations from the Red Cross consisting of food, cigarettes, and other items. Of course, not all prisoners valued
individual items the same. The English preferred drinking tea to coffee, whereas French prisoners preferred coffee to
tea. Some prisoners smoked heavily, whereas others were nonsmokers. Potential gains from trade quickly motivated
exchanges among prisoners. Before long, an organized market evolved. Cigarettes became the common currency.
Prisoners quoted prices for goods in terms of the number of cigarettes. The price of individual items depended on
supply and demand. For example, the price of chocolate would drop dramatically if a new Red Cross shipment
increased supply substantially. The markets at the prisoner-of-war camps were quite active and emerged without a
central planner saying “let’s create a market.” The welfare of the prisoners was significantly enhanced by the presence
of these markets—although they benefited substantially more when they were liberated!
Source: R. Radford (1945), “The Economic Organization of a P.O.W. Camp,” Economica 12, 189–201.
A C A D E M I C A P P L I C AT I O N S
4In Chapter 17, we discuss the economics of transfer pricing. 5In small firms, senior management and owners often are the same. In large firms, owners (the shareholders)
delegate most decision rights to the board of directors and the CEO. These parties are charged with
developing the architecture for the firm. In this chapter, we do not distinguish between senior managers and
owners. In subsequent chapters, we expand our analysis to discuss potential contracting problems between
these two groups.
Chapter 11 Organizational Architecture 359
Controls Through the delegation of decision rights, employees are granted authority over the use of company resources. Employees, however, are not owners: They cannot sell company property and pocket the proceeds. Therefore, employees have fewer incentives to worry about the efficient use of company resources than do owners. To help mitigate these incentive problems, managers must develop a control system, that is, managers must structure the other two basic pieces of the organization’s architecture—the reward and performance-evaluation systems that help align the interests of the decision makers with those of the owners. As we discuss below, an optimal control system, consisting of the system of rewards and the system that evaluates performance, depends on how decision rights are partitioned in the firm, and vice versa.
Trade-Offs Once the firm grows beyond a certain size, the CEO is unlikely to possess the relevant information for all major decisions. Consequently, the CEO faces three basic alterna- tives in designing organizational architecture. First, the CEO can make most major de- cisions, despite lacking relevant information. In this case, there are limited incentive problems and the development of a detailed control system is less critical.6 However, lacking relevant information the CEO is likely to make suboptimal decisions. Second, the CEO can attempt to acquire the relevant information to make better decisions. This option can enhance decision making. Yet obtaining and processing the relevant infor- mation can be both costly and time-consuming. Third, the CEO can decentralize deci- sion rights to individuals with better information. This choice assigns decision-making authority to employees with the relevant information. But delegating decision rights gives rise to increased incentive problems, which requires that control systems be de- veloped. Another potential drawback of decentralization involves the costs of transfer- ring information between the CEO and other decision makers in coordinating efforts across the organization.
M A N A G E R I A L A P P L I C AT I O N S
Organizational Architecture at Century 21 Century 21 International is the largest residential real estate firm in the world. In 2014, Century 21’s system consisted
of 7,100 independently owned and operated offices in 75 countries with more than 102,000 sales professionals. Given
the geographic and cultural diversity facing Century 21, it would not be productive for the U.S. headquarters to make
all major decisions. Such centralized decision making would be especially problematic for the international
operations, where laws and cultures can differ substantially from those in the United States. Rather Century
21’s central management helps the international regions develop their offices. Each international office has a great deal
of flexibility to design those practices and policies that best reflects their local housing market and real estate
traditions.
Decentralized decision making requires a control system that promotes productive effort. At Century 21, most of
the local operators are franchisees. Franchisees essentially are owners of their units and keep a large share of their
units’ profits. This ownership provides strong incentives to increase sales and value. Also, Century 21 reserves the
right to terminate individual franchises that fail to maintain acceptable levels of service.
Source: www.century21.com
6The manager still has a contracting problem in motivating lower-level employees to follow detailed
instructions. However, this contracting problem is likely to be less severe than when the manager gives the
lower-level employees greater discretion in making decisions.
360 Part 3 Designing Organizational Architecture
Of course, CEOs can choose a mix of these basic alternatives. For example, ex- ecutives generally choose to retain some decision rights while delegating others. The optimal choice, as we discuss later, depends primarily on the business envi- ronment and strategy of the firm. In some cases—especially in smaller firms oper- ating within relatively stable industries—senior managers are likely to have most of the relevant information for decision making, and thus decision rights are more likely to be centralized at headquarters. In other cases—especially larger firms ex- periencing rapid change—senior managers and their corporate staff often will not be in the best position to make a broad array of decisions. In such cases, decision rights are more likely to be decentralized, with corresponding control systems adopted and implemented.
This discussion indicates that the CEO plays a major role in framing the basic archi- tecture for the firm. Organizational decisions, however, are made by managers through- out the organization. For example, when the CEO delegates a set of decision rights to middle-level managers, these managers must decide which decisions to make them- selves and which decisions will be delegated to lower-level managers. These lower- level managers then are faced with similar organizational questions. The overall archi- tecture of a firm is determined through this process, ultimately involving employees throughout the organization.
Architectural Determinants As suggested above, optimal architectures will differ across companies. Such struc- tural differences are not random but vary in systematic ways with differences in cer- tain underlying characteristics of the companies themselves. To illustrate the point, companies operating in the same industry tend to develop similar architectures. If an important aspect of an industry’s environment changes, most companies in that in- dustry will react by readjusting their decision rights and internal control systems.
In Figure 11.1, we summarize those factors which are likely to be most important in designing the optimal architecture for a given firm. At the top of the figure are three aspects of the firm’s external business environment: technology, markets, and regulation. For any firm, these three factors—technologies that affect the production of or demand for its products, its methods of production, and its information systems; the structure of its markets (competitors, customers, and suppliers); and the regulatory constraints on its activities—are likely to have the greatest influence on its strategy. By strategy, we mean that broad set of issues discussed in Chapters 8 and 9, including the firm’s primary goals—nonfinancial as well as financial; the firm’s sources of comparative advantage; its choice of industry, products, and services; its target customers; and pricing policies.
Take the case of AT&T in the early 1980s, before it was separated into a long- distance carrier and regional operating companies called the Baby Bells. Regulation dictated many aspects of the firm’s strategy—what services it could offer, what cus- tomers it could serve, and how much it could charge them. After the breakup of AT&T and the accompanying deregulation of the telecommunications industry, both the Baby Bells and the new AT&T were forced to devise new strategies to provide new products, serve new customer bases, and develop new pricing structures.
As depicted in Figure 11.1, the ultimate goals of the firm, as reflected in its strat- egy, in turn affect its optimal organizational architecture. As the celebrated architect Louis H. Sullivan—designer of the first skyscraper and founder of the American school of architecture—once observed, “Form ever follows function.” Applying the
Chapter 11 Organizational Architecture 361
Business environment
Strategy
Organizational architecture
• Choice of industries • Basis for competition (price, quality, service)
• Decision-right assignment • Reward system • Performance-evaluation system
Incentives and actions
Firm value
Technology
• Computers • Telecommunications • Production methods
• Competitors • Customers • Suppliers
• Taxes • Antitrust • International
Markets Regulation
Figure 11.1 The Determinants of Strategy, Organizational Architecture, and Firm Value
Market conditions, technology, and government regulation are important determinants of strategy, which in turn helps determine organizational architecture. Two-way arrows are drawn to show important feedback effects. Both strategy and architecture affect the incentives and actions of employees within the firm and thus help determine the firm’s value.
M A N A G E R I A L A P P L I C AT I O N S
Big-Bang Disrupters Nuke Corporate Strategies With the plummeting cost of computing power coupled with the Internet’s ability to make new products go viral, firms
that were healthy and profitable one day, can be out of business the next because of a “Big-Bang Disrupter.” Take the
case of Sleep Health Centers, an operator of sleep disorders clinics where people stayed overnight to have their
ailments diagnosed. In 2012, new cheap, wearable devices began appearing that allowed people to sleep at home while
experts monitored their sleep remotely. Failing to devise a new strategy, Sleep Health Centers went out of business the
next year. Other stories of big-bang disrupters exist. Apple’s iTunes digital-music service adversely affected music
companies. When the Google maps smartphone app, with turn-by-turn navigation, was launched, firms selling portable
GPS navigation systems saw plummeting sales.
While Figure 11.1 depicts how changing technology, markets, and regulation affect a firm’s strategy, it is a rare firm
that can reinvent itself when “big-bang disrupters” hit. The evidence suggests that most firms are unable to find a new
viable strategy and simply fail.
Source: The Economist (2014), “The Big Bang Theory,” The Economist (January 11), 74.
362 Part 3 Designing Organizational Architecture
same principle within organizations, we see that significant changes in the business environment and hence in strategies typically call for major changes in decision- making authority, performance measures for evaluating employees, and incentive- compensation systems.
Returning to our telecommunications example, in the early 1980s a regulated AT&T faced little competition or pressure for technological innovation. It operated within a reasonably stable environment—one where it made sense for a huge formal bureaucracy to make the most important decisions from the top down. Since the breakup of the company, the telecommunications industry has experienced almost continuous upheaval, with deregulation, increased competition, and rapid technolog- ical change. In 1992, after a nearly decade-long series of incremental moves toward decentralization, AT&T established a large number of fairly autonomous profit cen- ters run by managers on pay-for-performance plans tied to their units. In 1995, AT&T broke itself into three separate publicly traded companies, an equipment company—Lucent Technologies, a computer company, NCR, and a communications services company (which retained the AT&T name). The break up resulted in 40,000 layoffs and represented the largest voluntary breakup in the history of American business.7 In 2005, one of the original Baby Bells, Southwestern Bell Corp, acquired AT&T Corp., creating the new AT&T.
Although in our discussion we have emphasized the effects of strategy on ar- chitecture, the effects are not all in one direction—note the two-headed arrow in Figure 11.1. Strategy also can be influenced by organizational architecture. A company might decide to enter a new market in part because its decision and con- trol systems are especially well-suited for this new undertaking. For instance, before the 1980s, Atlanta, Georgia, was widely acknowledged as the banking cen- ter of the South. Yet in 2014, Charlotte, North Carolina, claims the title. Bank branching historically was regulated by the states. Georgia limited its banks’ abil- ity to branch, while North Carolina permitted statewide branching. As restrictions
7www.att.com/gen/investor-relations?pid=5711b
M A N A G E R I A L A P P L I C AT I O N S
New Technology Provides Better Controls A key part of the firm’s organizational architecture involves controls—performance evaluation and rewards. All firms
must protect their assets from loss—intentional and unintentional. Over 5 percent of all container movements worldwide
develop transit problems. Twelve million cargo boxes enter the United States every year by ships, rail, and trucks.
International freight companies must have controls over their shipping containers to avoid theft and misroutings, not to
mention to prevent terrorists from using the boxes as a delivery system for explosives, chemicals, or nuclear bombs. The
shipping industry is turning to “smart containers”—devices attached to shipping boxes that relay the container’s current
location, content, and condition via satellite or radio to both shipper and receiver. While equipping containers with such
communication devices is not cheap—the cost per box ranges from $50 to $800 depending on functionality—the
savings from just preventing shipping errors can be large. One shipper was informed that its container of citric acid was
in Montreal (nowhere near its final destination in New Jersey) and had not moved in three days. The shipper called a
broker and got the cargo on its way.
Source: D. Machalaba and A. Pasztor (2004), “Thinking Inside the Box,” The Wall Street Journal ( January 15), B1.
Chapter 11 Organizational Architecture 363
on interstate banking fell in the 1980s, the North Carolina Banks—especially BB&T, NCNB (now Bank of America), First Union and Wachovia (who merged in 2001) exploited their experience in acquiring banks to create a statewide banking system to create regional and then national banks. These banks have been operat- ing quite successfully, in part because their organizational architectures were bet- ter-suited to the new regulatory environment.
As another example of how changes in the environment can affect organiza- tional architecture, consider the case of increased foreign competition in the 1980s and 1990s. For years, many large American companies (e.g., ITT, IBM, General Motors, Eastman Kodak, and Xerox) faced limited competition in their product markets. Many of these companies had substantial market power and had little ex- ternal impetus to focus on rapid product development, high-quality production, or competitive pricing. Their organizations were highly bureaucratic, with quite cen- tralized decision making and limited incentive compensation. Many of these firms experienced a dramatic increase in foreign competition over the past two decades—especially from the Japanese. This competition forced these large firms to rethink their basic strategies and increase their emphasis on quality, customer service, and competitive pricing. To accomplish these objectives, firms often had to change their organizational architectures. They frequently pushed decision rights lower in the organization, where specific knowledge about customer demands was located (recall the example of Brabantia). They also increased their use of incentive compensation and developed performance-evaluation systems that focused on quality and customer service. And in some cases like Kodak, the firm is unable to devise a viable strategy to address the foreign competition and new technologies; and eventually fail to survive.
In some ways, Figure 11.1 provides an overly simplified view of the determi- nants of strategy, architecture, and firm value. The figure admittedly ignores potentially important feedback effects among the environment, business strategy, and architecture. Consider, for example, how Microsoft invests resources to develop software that, in turn, alters the basic technology facing the firm. Large firms also often have political power that can be used to influence government regulation. Even though these types of feedback effects at times can be important, in most circumstances managers must take the business environment essentially as given. This environment, in turn, largely determines what the firm can expect to accomplish (its strategy) and its architecture. Figure 11.1 provides managers with a structured way of thinking about the factors that are likely to affect their firm’s architecture. We use this structure throughout the book for analyzing orga- nizational decisions.
ANALYZING MANAGERIAL DECISIONS: Tipping in Restaurants
In most restaurants, waiters receive a large portion
of their compensation through tips from customers.
Generally, the size of the tip is decided by the cus-
tomer. However, many restaurants require a 15 per-
cent tip for parties of eight or more. Using the con-
cepts from this chapter, discuss (a) why the practice
of tipping has emerged as a major method of com-
pensating the wait staff, (b) why the customer typi-
cally decides on the amount of the tip, and (c) why
restaurants require tips from large parties.
364 Part 3 Designing Organizational Architecture
Changing Architecture
Although changes in market conditions, technology, or government regulation can af- fect appropriate organizational design, organizational change is by no means a costless process. It is important to assess the costs as well as the benefits in evaluating the mer- its of an organizational restructuring. Organizational change should be undertaken only when the expected incremental benefits exceed the expected incremental costs.
First, there are direct costs. The new architecture has to be designed and commu- nicated to employees throughout the company. Moreover, changes in architecture frequently require costly changes in the firm’s accounting and information systems. Sometimes, what appears to be a straightforward change in the performance- evaluation system is a major and costly project for the firm’s data processing and accounting departments. Literally hundreds of computer programs might have to be modified to alter the accounting and information systems.
Second, and perhaps more important, are indirect costs. Changes in architecture are likely to affect some employees positively—for example, by increasing their responsi- bility and possibilities for rewards—but others negatively. Thus, the attitudes toward change are likely to vary among employees. Dealing with the associated incentive problems of implementing change in a firm can be expensive (see Web Chapter 20, available via Connect). In addition, frequent changes in architecture can have unde- sirable incentive effects. Increasing the likelihood that workers will change assign- ments in the near future reduces their incentives to invest in learning current job assignments, devising more efficient production processes, and developing effective relations with coworkers. Frequent restructuring within a firm causes uncertainty about job assignments and will promote actions that focus more on short-run payoffs and less on long-run investments.
M A N A G E R I A L A P P L I C AT I O N S
Changing Organizational Architecture Requires Careful Analysis At any point in time, a particular set of prominent management techniques is touted as the key to success. Popular
techniques include “leadership by kindness and gentleness,” reengineering, benchmarking, total quality management,
worker empowerment, the learning organization, and skill-based pay. Most of these techniques involve fundamental
changes in organizational architecture. For example, advocates of total quality management commonly recommend
delegating decision rights to teams and not paying incentive compensation based on individual performance.
Adopting the most recent business trend or fad can get a firm in trouble unless the change is warranted by the actual
circumstances facing the firm. Unfortunately, many firms appear to adopt changes without careful analysis of the
relevant costs and benefits. One commentator argues, “There’s an industry out there selling leadership ‘secrets’ to
executives in American industry, and it seems to have an insatiable customer base” of insecure managers wanting to
spout the latest buzzwords.*
Managers should not change their organization simply because it is the current fad. Certainly, some organizational
changes can enhance value. However, managers should consider carefully whether the benefits of a change are larger
than the costs, given their particular circumstances. (See Web Chapter 23, available via Connect, for a detailed analysis
of management innovations.)
*B. Lutz (2012), “‘Leadership By Kindness’ and Other Dumb Management Fads,” Forbes (May 12), www.forbes.com/sites/boblutz/
2012/05/02/leadership-by-kindness-and-other-dumb-management-fads
Chapter 11 Organizational Architecture 365
Interdependencies and Complementarities within the Organization
It is important to understand that the components of organizational architecture are fundamentally interdependent. The appropriate control system depends on the alloca- tion of decision rights, and vice versa. For example, if decision rights are decentral- ized, it is important to have a control system (performance measurement and rewards) that provides incentives for employees to make value-enhancing decisions. Reward and performance-evaluation systems have to be developed that compensate employ- ees based on performance outcomes. Similarly, if a firm adopts a compensation plan to motivate employees, it is important to grant employees decision rights so that they can respond to these incentives. In this sense, the components of organizational ar- chitecture are like three legs of a stool. It is important that all three legs be designed so that the stool is balanced and functional. Changing one leg without careful atten- tion to the other two is typically a mistake. For example, it is unlikely that Brabantia would have been as successful if managerial decision rights had been changed with- out accompanying changes in the firm’s compensation plan.
Organizational architecture interacts with an array of other interrelated policies and systems within the firm. For example, incentive–compensation schemes for lower- level managers often are based on accounting performance for their particular business units. Changing business-unit structure and associated compensation plans therefore can require changes in the firm’s accounting system. Similarly, it might be effective to pay the manager of a subsidiary based on the stock market performance of the sub- sidiary. But, for this policy to be implemented, shares in the subsidiary must be pub- licly traded. Thus, there can be interdependencies between the organizational architec- ture and the firm’s financing policies. As another example, consider the design of the firm’s organizational architecture and its computer/information systems. New com- puter programs provide expert systems that allow low-skilled workers to complete complicated tax returns, assess the qualifications of mortgage applicants, and perform other tasks that previously required extensive training and experience. These programs have allowed financial services companies to decentralize additional decision rights to lower-level employees. For example, lower-level employees in some financial institu- tions now have the rights to approve mortgage applications without supervisor ap- proval if the computer program indicates that the applicant is qualified.
The three parts of the firm’s Organizational Architecture in Figure 11.1 (decision- right assignment, the reward system, and the performance-evaluation system) along with other firm policies are not just interdependent, but should be chosen to comple- ment the other parts and policies. Two or more organizational policies are said to be complements when doing more of one increases the returns from doing more of the
Changing Organizations Too Frequently: Not a New Phenomenon We trained hard, but it seemed that every time we were beginning to form into teams we would be reorganized. I was to
learn later in life that we tend to meet any new situation by reorganizing, and what a wonderful method it can be for
creating the illusion of progress while producing confusion, inefficiency, and demoralization.
Petronius Arbiter, 210 BC.
H I S T O R I C A L A P P L I C AT I O N S
366 Part 3 Designing Organizational Architecture
others. When complementary policies are employed together the “whole is greater than the sum of the parts.” A well-designed organization typically makes balanced use of a host of complementary policies (either high or low use of all of them).8 For example, a firm that decentralizes decision rights will generally find it optimal to spend more resources on recruiting talented employees, training and development, performance measurement and incentive compensation. In contrast, a firm with highly centralized decision making will likely want to limit expenditures on all of these activities. The fact that many organizational policies are complements simplifies the organizational design problem to some extent. Rather than having to choosing many policies independently, managers can often limit their attention to a much smaller subset of “coherent systems,” in which simultaneous high or low use is made of multiple policies. The optimal choice for any given firm depends on its business environment and strategy. In this book, we focus our attention on the three components of Organizational Architecture. However, good managers select other organizational policies (such as the employee recruitment process and training programs) to complement their firm’s Organizational Architecture.
Corporate Culture Corporate culture is one of the more frequently used terms in the literature on orga- nizations. Corporate culture usually encompasses the ways work and authority are organized, the ways people are rewarded and controlled, as well as organizational features such as customs, taboos, company slogans, heroes, and social rituals. Man- agers are exhorted to develop high-powered, productive cultures. Yet, little concrete guidance is provided on how to accomplish this goal.
Our focus on organizational architecture is consistent with this concept of corpo- rate culture. Indeed, our definition of organizational architecture corresponds to key aspects of what frequently is discussed as corporate culture. For example, the archi- tecture specifies how authority (decision rights) is distributed among employees and how rewards are determined. An advantage of our approach is that it defines the key components of a firm’s corporate culture and analyzes how managers might affect culture through identifiable actions.
As an example, recall our discussion of Merrill Lynch in Chapter 2. The old cor- porate culture at Merrill could be characterized as an environment where dishonest analysts regularly misled customers. After the scandal became public, Merrill had to find a way to change this corporate culture. Our approach provides direct guid- ance on how this change might be accomplished—in this case, by changing the compensation scheme.
Some dismiss the “softer” elements of corporate culture—for example, role models, company folklore, and rituals—as being unimportant. Rather, they stress formal archi- tecture as being the primary, if not sole, determinant of a firm’s value.9 Economics, however, suggests at least two important roles for these elements of corporate culture: enhancing communication and helping to set employee expectations.
8J. Roberts (2004), The Modern Firm: Organizational Design for Performance and Growth (Oxford University Press: Oxford).
9For instance, managers who subscribe to the teachings of Frederick Taylor believe that the designs of work
processes and incentive systems are the primary determinants of firm value. F. Taylor (1923), The Principles of Scientific Management (Harper & Row: New York).
Chapter 11 Organizational Architecture 367
Corporate Culture and Communication Most organizations do not write down all important features of their organizations in detailed procedures manuals. Rather, these features typically are communicated to em- ployees in less formal yet frequently more effective ways. Aspects of the corporation such as slogans, role models, and social rituals can be methods of communicating organizational architecture to workers in a particularly memorable way. A slogan like At Ford, Quality Is Job 1 emphasizes that workers are expected to focus on quality and customer service and that this focus will be rewarded by the company. Given this slogan and other reinforcing signals from top management, employees at Ford have a reasonably clear idea of how to respond to situations such as angry customers, even without formal policies to follow. But after 17 years, Ford dropped this slogan and adopted the new slogan in 1998 of “Better ideas. Driven by you.” In 2014, Ford’s slogan is “Go further.” Besides slogans, social rituals, such as training sessions and company parties, can help disseminate information by increasing the interaction among employees who otherwise might not see each other on a frequent basis. Singling out role models or heroes for special awards is another way of communicat- ing explicitly what the company values.
Less tangible features of organizations, such as rituals and role models, can be im- portant in reinforcing and communicating organizational architecture. However, they also can increase the costs of changing architecture. Managers can change formal eval- uation and compensation schemes and clearly communicate these changes to the rele- vant employees. But getting employees to change their heroes, customs, and social rit- uals can be more time-consuming and difficult. These features often are created through informal communication channels: They take time to dismantle as well as to create.
M A N A G E R I A L A P P L I C AT I O N S
Netflix Corporate Culture Goes Viral In 2009, Netflix released internally a 128-slide document titled “Reference Guide on our Freedom & Responsibility
Culture.” By 2014, it has been viewed by over 5 million on the Internet. Facebook chief operating officer Sheryl
Sandberg says it “may well be the most important document ever to come out of the (Silicon) Valley.”
The document starts by describing its culture as: “What gives Netflix the best chance of continuous success for
many generations of technology and people?” It then goes on to list seven aspects of its culture: (1) “values are what
we value,” (2) high performance, (3) “freedom & responsibility,” (4) “context, not control,” (5) highly aligned, loosely
coupled,” (6) pay top of market, and (7) promotions & development. Each of these seven aspects is fully explained. For
example, under “values are what we value” nine specific behaviors are described as valuable such as judgment,
courage, and honesty. The slide deck then describes current Netflix policies that follow from each of the seven aspects.
For example, under the second culture aspect, “high performance,” Netflix managers are told to apply “The Keeper
Test: Which of my people … would I fight hard to keep at Netflix? The other people should get a generous severance
now, so we can open a slot to try to find a star for that role.” Under the third culture aspect, “freedom & responsibility,”
two policies are described. The policy on employee reimbursement for travel and entertainment expense is “Act in
Netflix’s Best Interests.” And, the policy on how many vacation days employees are allowed and tracking vacation
days is: “There is no policy or tracking.”
Netflix’s corporate culture statement is one of the most elaborate and detailed, and illustrates how one company
tries to communicate the desired behaviors and qualities it seeks in its employees.
Source: www.slideshare.net/reed2001/culture-1798664; and A. Shontell (2013), “Sheryl Sandberg: The Most Important Document Ever
to Come Out of the Valley,” Business Insider (February 4).
368 Part 3 Designing Organizational Architecture
Corporate Culture and Employee Expectations In the appendix to Chapter 9, we illustrated how the decisions of employees to exert effort and to cooperate with other employees can depend on their expectations about how other individuals will respond. In this example, employees work hard only if they think that other employees will work hard as well. Expectations of how other in- dividuals will behave are shaped, in part, by the formal architecture of the firm. If Ehud Rabin observes that Colleen O’Shea is paid a commission on sales, it is rea- sonable for Ehud to forecast that Colleen will exert some effort in trying to increase sales. Expectations, however, also are affected by less formal aspects of corporate culture. For example, Microsoft has developed a reputation for hiring creative, hard- working individuals. If two Microsoft employees are placed together on a team, it is reasonable for each to expect that the other is clever and industrious.
This analysis suggests that it generally will be advantageous for managers to use both the formal architecture as well as the less formal aspects of corporate culture to foster expectations that promote productive choices by employees. For instance, sup- pose that employees are most likely to focus on quality if they think other employees have the same focus. A manager interested in increasing manufacturing quality thus might supplement changes in the formal evaluation and reward systems with slo- gans, executive speeches, employee relations campaigns, and clever use of the media, all aimed at creating a “quality-centered” culture.
A System of Complements Features of organizations like rituals and role models can be effective in reinforcing and communicating the goals of the firm, and they possess the potential to produce in- fluential aspects of a coherent architecture. Their effectiveness in specific cases has led some management gurus to claim that a productive corporate culture can be molded with no attention to formal evaluation and compensation schemes. Some people—for instance, quality expert W. Edwards Deming—argued that incentive pay
M A N A G E R I A L A P P L I C AT I O N S
Firms Use the Clout of Their Well-Connected Employees A number of companies including Procter & Gamble Co. and Cisco Systems Inc. identify those among their
employees who are particularly well-connected and trusted by their peers. These so-called “influencers” are then used
to help develop new products, get other workers on board with big changes like mergers, or help disseminate
information throughout the firm.
Often these influencers are identified by analyzing social media sites to see who has the most friends or the most
connections. For example, Health Fitness Corp., a provider of corporate health services, mapped its social networks to
identify employees who could help convince others of the importance of a major new technology platform. The
company flew 30 influencers to its corporate offices to describe the project further and to build positive buzz among
the other employees. The CEO of Health Fitness believes that the influencers helped in the transition to the new IT
platform. The influencers also benefit with more money, possible promotions, and hobnobbing with top executives.
While the rise of social media and social networks can be used to identify influencers who can help improve
communications throughout the firm, such programs also come with costs. If the firm rewards being an “influencer,”
employees will spend more time developing their networks, at the expense of doing other productive activities for the
firm. Moreover, people can game the system to appear to be more “influential” than they really are.
Source: R. Feintzeig (2014), “Office ‘Influencers’ Are in High Demand,” The Wall Street Journal (February 12), www.wsj.com/articles/ SB10001424052702303874504579375313680290816
Chapter 11 Organizational Architecture 369
actually is detrimental to a productive organization. Our analysis suggests that it is a mistake to think of these hard and soft aspects of the organization as mutually exclu- sive or in competition with each other; both can play a valuable role in increasing firm value. The various elements of the organization are more likely to be complements than substitutes. In Chapter 20, we present a detailed discussion of Xerox’s early
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Scandal-Plagued European Banks Seek to Change Their Corporate Culture A number of prominent U.K. banks have suffered a series of high-profile scandals involving circumventing regulatory
rules, attempting to rig interbank lending rates (LIBOR), manipulating foreign exchange trading, and excessive
compensation paid to senior managers. The media, politicians, and regulators blame the bankers for fostering a culture
of excessive risk taking, greed, and bad behavior. To address these criticisms, some banks including Royal Bank of
Scotland, HSBC U.K., Barclays, and Deutsche Bank (Germany) have attempted to change their corporate culture,
often by hiring outside consultants. These consultants offer advice on ways to improve bankers’ behavior at work.
Using their consultants, banks have tried various approaches to changing their corporate culture. To highlight the
softer side of the banking industry Citigroup’s London office began a choir that performed on television. Barclays
changed its office notepads to now contain phrases such as “Respect,” “Integrity” and “Stewardship.” Deutsche Bank
required 300 managing directors to attend time-consuming culture sessions at a research institute in Cologne,
Germany. And to learn about managing in difficult environments Barclays sent top managers to an orphanage in Africa.
Some people believe banks can change their corporate culture. One U.K. lawmaker says, “there is a long, long way
to go before we feel that the culture of banks has fundamentally changed.” But another lawmaker argues that the
various attempts to change culture are ineffective, “If [banks] think that is enough, then we are all screwed.”
It is not clear whether these corporate culture change programs are designed as public relation ploys to pander to
the public and appease lawmakers from writing tougher regulations, or if the banks believe that such programs really
do work. The analysis in this chapter predicts that changing corporate culture will be very difficult and time-
consuming. Firms attract and retain employees with personal characteristics, most valuable to the firm. Changing
cultures often involves changing the characteristics of the firm’s work force, often by gradually replacing the existing
work force as they retire or quit with new employees with the now desired characteristics. And such a change will most
likely be challenged by the existing employees with those characteristics that are now out of favor.
Source: M. Colchester (2014), “Scandal-Hit British Banks Turn to ‘Weirdy Beardy’,” The Wall Street Journal (March 26), www.wsj.com/articles/SB10001424052702304418404579463122893382480
The Value of Corporate Culture A study of S&P 500 companies found 85 percent of them have on their websites a section called “corporate culture”
where they list those values that comprise their culture. Eighty percent of these websites list “innovation” followed by
“integrity” or “respect” (70 percent). The researchers are unable to find any correlation between the frequency and
prominence of these values to measures of short- and long-term performance.
The researchers then turn to survey data of employees of more than 1,000 U.S. firms that measure how cultural
values are perceived by employees, including the level of integrity of management as perceived by the employees.
Interestingly, the study documents that high levels of perceived integrity are positively correlated with higher
productivity, profitability, and higher level of attractiveness to prospective job applicants.
The study suggests that firms with high-integrity managers perform better, but just listing “integrity” as part of the
firm’s corporate culture is “cheap talk.”
Source: L. Guiso, P. Sapienza, and L. Zingales (2013), “The Value of Corporate Culture,” National Bureau of Economic Research (October).
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370 Part 3 Designing Organizational Architecture
efforts to increase product and service quality. Xerox CEO David Kearns initially fo- cused on softer elements—slogans, speeches, and media campaigns—in his efforts to foster a quality culture within his organization. He soon realized that to be effective, he also had to change the company’s formal evaluation and reward systems.
When Management Chooses an Inappropriate Architecture Sometimes, managers are either unable or unwilling to design value-increasing ar- chitectures or strategies. Consider the management at RJR-Nabisco in the late 1980s, as highlighted in Chapter 10. In cases such as RJR-Nabisco, value can be created by replacing existing management with new managers who are willing and able to choose architectures and strategies that increase value.
Firing the Manager In public corporations, the board of directors has the decision rights to hire, fire, and compensate senior managers. Evidence indicates that boards are most likely to fire managers when firm performance is poor (as measured by stock returns and account- ing earnings).10 Consider Eastman Kodak in 1993. The company was performing poorly, and senior managers acknowledged that a poorly designed architecture was among the company’s most significant problems. These managers were unable to de- sign a better one. The board of directors fired the CEO and hired a new one. The new CEO, George Fisher, rapidly changed both the architecture and the strategy of the com- pany. The stock market greeted these actions with a substantial increase in the Kodak stock price. At the end of this chapter, we present a case study of this example.
Although firing the CEO is a relatively rare event, firings at other management levels are more common. When middle managers perform poorly by implementing ineffective strategies and inappropriate architectures for their business units, they can be fired or reassigned by senior managers. Middle managers, in turn, have deci- sion rights to replace lower-level managers.
Market for Corporate Control Another mechanism for replacing poor management is the market for corporate con- trol—for example, tender offers and mergers. During the last few decades, the wealth of shareholders has increased by billions of dollars due to corporate takeovers. Typ- ically, when a poorly performing company is acquired by another company, its man- agement is replaced.11 The architecture and strategy also are changed as a result. ITT’s poor performance in 1988 motivated takeover speculation. Existing manage- ment took actions to increase the firm’s value, and a takeover did not materialize. In contrast, the former management team at RJR-Nabisco did not make the necessary changes to increase its firm’s value, and the company was acquired by Kohlberg, Kravis, Roberts & Company. KKR subsequently replaced the management team and implemented significant changes in RJR’s architecture and strategy.
10J. Warner, R. Watts, and K. Wruck (1988), “Stock Prices and Top Management Changes,” Journal of Financial Economics 20, 461–492; and M. Weisbach (1988), “Outside Directors and CEO Turnover,” Journal of Financial Economics 20, 431–460. Similar evidence is observed in the nonprofit sector; see J. Brickley and L. van Horn (2002), “Incentives in Nonprofit Organizations: Evidence from Hospitals,”
Journal of Law and Economics 45, 227–249. 11For a summary of the evidence on corporate takeovers, see B. Eckbo (2010), Modern Empirical
Developments in Corporate Takeovers (Elsevier/Academic Press: Amsterdam).
Chapter 11 Organizational Architecture 371
Product Market Competition When all else fails, inefficient firms eventually go out of business. In Chapter 6, we discussed how competitive pressures tend to drive prices toward marginal cost. If a firm is inefficient and cannot cover its total costs at these prices, it eventually has to shut down. As discussed in Chapter 1, this competitive process resembles natural se- lection in biology—the strong survive. It is a process we refer to as economic Dar- winism. Enron is a dramatic example of a firm that became insolvent due to the poor design of its architecture.
Managerial Implications Organizational architecture provides a powerful framework for addressing management problems throughout the organization. In many cases, a problem can be traced directly to defects in organizational architecture (consider Enron and Merrill Lynch). By using this framework, managers can identify problems more quickly and craft solutions more effectively. In analyzing business problems and cases, students and managers often find it useful to refer to Figure 11.1 and ask themselves the following set of questions:
• Does the strategy fit the business environment (technology, market conditions, and regulation) and the capabilities of the firm?
• What are the key features of the current architecture?
• Does the current architecture fit the business environment and strategy? In particular, does the architecture link specific knowledge and decision rights in an effective manner and provide incentives to use information productively?
Marmots and Grizzly Bears Business writers, consultants, and government regulators frequently claim that existing business practices are
inefficient, and they propose changes that allegedly would improve productivity. The principle of economic Darwinism,
however, suggests that many of these claims are likely to be misguided. In a competitive world, if organizations survive
over the long run with a particular architecture, it is unlikely that there is some obvious change that could be implemented to increase profits. Sometimes the reasons for survival of a particular practice might not be clear to an
outside observer. Existing practices, however, should not be deemed inefficient without careful analysis.
The interaction between marmots and grizzly bears serves to illustrate this point. Marmots are small groundhogs and
are a principal food source for certain bears. Zoologists studying the ecology of marmots and bears observed bears
digging and moving rocks in the autumn in search of marmots. They estimated that the calories expended searching for
marmots exceeded the calories obtained from consuming marmots. Thus, searching for marmots appeared to be an
inefficient use of the bear’s limited resources. Given Darwin’s theory of natural selection, bears searching for marmots
should become extinct. A well-meaning consultant or government regulator, therefore, might recommend that bears quit
searching for marmots.
Fossils of marmot bones near bear remains, however, suggest that bears have been searching for marmots for quite a
long time. An explanation is that searching for marmots provides benefits to bears in addition to calories. For instance,
bears sharpen their claws as a by-product of the digging involved in hunting for marmots. Sharp claws are useful in
searching for food under the ice after winter’s hibernation. Therefore, the benefit of sharpened claws and the calories
derived from marmots offset the calories consumed gathering the marmots. The moral is that in biology or business, an
outside observer should be cautious in concluding that long-standing practices are inefficient without careful study.
Source: J. McGee (1980), “Predatory Pricing Revisited,” Journal of Law & Economics 23:2, 289–330.
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372 Part 3 Designing Organizational Architecture
• Are the three legs of the stool mutually consistent? Given the decision-right system, does the control system fit, and vice versa?
• If the answers to any of the previous questions suggest a problem, what changes in strategy and architecture should the firm consider?
• What problems will the firm face in implementing these changes?
Evaluating Management Advice
In a competitive marketplace, surviving firms tend to be those firms with the most productive strategies and architectures, given their business environments. This prin- ciple suggests that architectures are not random. There are sound economic explana- tions for the existing architectures within most industries. Consultants, however, fre- quently argue that long-standing practices obviously are inefficient and that companies would be better off by following their advice in changing the architec- ture. For example, many recent books on empowerment argue that most firms have made mistakes over a long time period in not delegating more decision rights to lower-level employees. Correspondingly, profits would be improved by further em- powering workers. Although this advice clearly makes sense for some firms in some environments (especially if the environment recently has undergone some fundamental change that favors decentralization of decision rights), our analysis suggests that managers should be cautious in condemning prevailing organiza- tional architecture without careful analysis. The discussion in the subsequent chapters provides important material to help conduct this analysis.
Benchmarking
Firms frequently benchmark other firms in an attempt to determine value-increasing policies. For example, a firm considering a change in its executive compensation plan is likely to collect information on the compensation plans of other similar firms.
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Benchmarking the Lincoln Electric Company Lincoln Electric company has had a long history of delivering large profits. Often, this record is attributed to Lincoln’s
unique reward system, which places a heavy emphasis on incentive compensation (we describe this system in detail in
Chapter 13). Managers from all over the world come to the Lincoln Electric headquarters at Cleveland, Ohio, to study
the system. Our analysis suggests that these managers should consider Lincoln’s business environment, strategy, and
other elements of organizational architecture (for instance, its decision-right system) in their benchmarking. Lincoln’s
success should not be attributed to its reward system alone but to how well this feature fits with its environment and
overall architecture.
Interestingly, Lincoln managers made the costly mistake of ignoring the complementary nature of these systems
themselves. During the 1980s, the management at Lincoln decided to export its incentive system internationally
through a series of mergers throughout Europe, Asia, and Latin America. Unfortunately, the system did not fit the
business environments at many of their new locations. For instance, the influence of unions in Germany and labor laws
in Venezuela made it impossible for Lincoln to implement its compensation system successfully. Lincoln ended up
losing millions of dollars on these ventures. Lincoln might have avoided these mistakes if in its decision-making
process it had applied carefully the framework discussed in this book.
Chapter 11 Organizational Architecture 373
This practice has obvious merit. Firms that survive in the marketplace tend to have strategies and architectures that fit their environment, and studying these firms has the potential to yield valuable insights. Our analysis has at least three implications for effective benchmarking. First, different architectures are appropriate for different environments. It is important to benchmark firms facing similar environments. Sec- ond, since it is unusual to find firms in identical environments, it is important to un- derstand any differences in the environments of the benchmarked firms and to take these differences into account when analyzing the data on firms’ policy choices. Third, it is important to view the architecture of other firms as a system of comple- ments. Studying a single feature of another firm’s architecture, without considering how it fits with other complementary elements of its architecture, can produce erro- neous conclusions and lead to dysfunctional changes.
Summary Organizational architecture includes three important components of organizational design that are major determinants of the success or failure of firms:
• The assignment of decision rights
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals and business units
The fundamental problem facing both firms and economic systems involves try- ing to ensure that decision makers have the relevant information to make good deci- sions and that these decision makers have appropriate incentives to use their infor- mation productively. The price system provides an architecture that helps solve this problem in markets. Through market transactions, decision rights tend to be trans- ferred to individuals with the relevant knowledge to make productive use of the re- sources. The market also provides a mechanism for evaluating and rewarding the performance of resource owners—owners bear the wealth effects of their actions. A valuable feature of markets is that this architecture is created spontaneously with lit- tle conscious thought or human direction.
Markets are not always the most efficient method for organizing economic activity—frequently, firms are more efficient. Within firms, there is no automatic system for either assigning decision rights to individuals with information or motivating individuals to use information to promote the firm’s objectives. Organizational architecture has to be created. The appropriate architecture depends on the environment facing the firm. In some firms, senior management will have most of the relevant information for decision making, and relatively centralized de- cision making is more likely to be adopted. In firms where lower-level employees have the relevant information, decision rights are more likely to be decentralized. In this case, reward and performance-evaluation systems must be developed to control incentive problems and to promote better decision making.
Market conditions, technology, and government regulations interact to determine the firm’s appropriate strategy and architecture. The strategy and architecture, in turn, are major determinants of the firm’s value.
Changes in the external business environment can motivate changes in the firm’s organizational architecture. Changing architecture, however, is costly. In addition to the direct costs of designing and implementing new procedures, there are potentially important indirect costs. Thus, changing architecture should be done only following careful analysis.
374 Part 3 Designing Organizational Architecture
The components of organizational architecture are highly interdependent. They are like three legs of a stool. Changing one leg without careful attention to the others is usually a mistake. Organizational structure also is related to other policies and sys- tems within a firm, including the accounting and information systems, marketing, and financial policy.
Corporate culture is a frequently used term. Corporate culture usually is meant to encompass the ways work and authority are organized and the ways people are rewarded and controlled, as well as organizational features such as customs, taboos, company slogans, heroes, and social rituals. Our focus on organizational architecture is consistent with this concept of corporate culture. Indeed, our defin- ition of organizational architecture corresponds to key aspects of what is fre- quently defined as corporate culture. The advantage of our approach is that it de- fines the key components of corporate culture and analyzes how managers might affect culture through conscious action. It also helps explain why corporate cul- tures of firms vary systematically across industries—different environments moti- vate different architectures. Elements of corporate culture like customs, social rit- uals, folklore, and heroes perform at least two important roles: Enhancing communication and fostering more productive expectations among employees. These elements, however, are likely to be less effective unless they are reinforced by the formal architecture of the firm.
Sometimes, managers are unable or unwilling to adopt value-maximizing archi- tectures or strategies. In such cases, value can be created through management re- placement. Management replacement occurs through firings and corporate takeovers. If a firm remains inefficient, it eventually will go out of business in a com- petitive marketplace.
This chapter introduces the concept of organizational architecture and provides a broad overview of the factors that are likely to be important in determining the optimal architecture for a particular organization. The next six chapters contain a more in-depth discussion of each of the three components of organizational archi- tecture: the assignment of decision rights, the reward system, and the performance- evaluation system.
M. Jensen (1983), “Organization Theory and Methodology,” The Accounting Review 58, 319–339.
M. Jensen and W. Meckling (1995), “Specific and General Knowledge, and Organizational Struc-
ture,” Journal of Applied Corporate Finance 8:2, 4–18.
D. Kreps (1990), “Corporate Culture and Economic Theory,” in J. Alt and K. Shepsle (Eds.),
Perspectives on Positive Political Economy (Cambridge University Press: Cambridge).
P. Milgrom and J. Roberts (1995), “Complementarities and Fit: Strategy, Structure and Organiza-
tional Change in Manufacturing,” Journal of Accounting and Economics 19, 179–208. Focus particular attention on pages 191–208.
J. Roberts (2004) The Modern Firm: Organizational Design for Performance and Growth (Oxford University Press: Oxford).
11–1. Suppose that a manager decides that a company’s decision making is too centralized. Will simply delegating more decisions to lower-level employees solve the problem? Explain.
11–2. Traditionally, many public utility companies (such as telephone and electric companies) have been highly regulated by the government. Thus, they have operated in stable envi-
ronments, shielded from competition and rapid change. Recently, deregulation has
Self-Evaluation Problems
Suggested Readings
Chapter 11 Organizational Architecture 375
substantially altered the environments of some of these companies. For the first time, they
are being exposed to intense competition from other companies. Discuss how this change
in the environment is likely to affect the optimal organizational architecture of utility
companies.
Solutions to Self-Evaluation Problems 11–1. No. The other components of architecture (rewards and performance evaluation) probably
also have to be changed to provide incentives to lower-level employees to make productive
decisions.
11–2. Traditionally, public utilities have had relatively centralized decision making and have made limited use of incentive compensation (especially for lower-level managers and employees).
Given the changes in the business environment, it is likely that local specific knowledge
will become more important. For example, the tastes and preferences of customers can be-
come more important to a company as it faces increased competition. Also, maintaining
state of the art technology can become more important. These arguments suggest that dereg-
ulation might motivate a further decentralization of decision rights. Correspondingly, to
make the three legs of the stool balance, one might expect increased use of incentive com-
pensation. Empirical studies of deregulated industries tend to support these conjectures.
11–1. Describe the three aspects of organizational architecture.
11–2. What is a major difference between the architectures of markets and firms?
11–3. How might the softer elements of corporate culture help increase productivity in an organi- zation? Give some examples of how managers might foster these elements to implement de-
sired change in an organization.
11–4. Prominent management consultants sometimes argue that decision making in teams is usu- ally more productive than decision making by individuals (important synergies arise when
teams operate that are absent when individuals work by themselves). These consultants sug-
gest that most companies have long failed to make proper use of teams. Their advice is that
most firms should increase their use of teams significantly. Critique this advice.
11–5. Assume that some firms within the same industry are observed to be multidivisional, whereas others are functionally organized. Assume further that all firms are about the same
size and have existed for a long period of time in their current organizational structures. Is
this observation inconsistent with the “survival of the fittest” concept discussed in class?
Explain.
11–6. Evaluate the following argument:
Management fads make no sense. One day it’s TQM. The next, it is empowerment or busi- ness-process reengineering. There is no economic justification for these fads. Manage- ment are just like sheep following each other to the slaughter.
11–7. Some of the electric generating plants of the Tennessee Valley Authority are powered by coal. Coal is purchased by a separate procurement division and is transferred to the plants
for use. Plant managers often complain that the coal is below grade and causes problems
with plant maintenance and efficiency. What do you think is causing this problem? What
changes would you make to help correct this problem?
Review Questions
chapter
12 C H A P T E R O U T L I N E
Assigning Tasks and Decision Rights
Centralization versus Decentralization
Benefits of Decentralization
Costs of Decentralization
Illustrating the Trade-offs
Management Implications
Lateral Decision-Right Assignment
Assigning Decision Rights to Teams
Benefits of Team Decision Making
Costs of Team Decision Making
Management Implications
Decision Management and Control
Decision-Right Assignment and Knowledge Creation
Influence Costs
Summary
Appendix: Collective Decision Making
Decision Rights: The Level of Empowerment
1Details of this example are from C. Chandler and P. Ingrassia (1991), “Just as U.S. Firms Try
Japanese Management, Honda Is Centralizing,” The Wall Street Journal (April 11), A1; M. Williams (1993), “Redesign of Honda’s Management Faces First Test with Unveiling of New
Accord,” The Wall Street Journal (September 1), B1; E. Thornton, L. Armstrong, and D. Woodruff (1998), “Honda: A Heckuva Time to Switch Drivers,” BusinessWeek (August 31), 42–44; and Y. Kageyama (2005), “Honda Profits Increase 27%,” Detnews.com (April 27).
L E A R N I N G O B J E C T I V E S
1. Explain how jobs vary in their assignment of tasks and decision authority. 2. Describe the costs and benefits of centralization versus decentralization. 3. Describe the trade-offs between vertical and horizontal (lateral) decision-rights
assignments.
4. Understand the costs and benefits of assigning decision rights to teams. 5. Compare the differences between decision management rights and decision control
rights and explain how separating decision management from decision control mit-
igates agency problems.
6. Define influence costs and describe how they can affect the assignment of decision rights within a firm.
H onda Motor Company was founded in 1948 by Soichiro Honda.1
Initially, decision making within the company was quite central- ized. Mr. Honda made virtually all product and design decisions, whereas finance and marketing decisions were made by his
partner, Takeo Fujisawa. In 1973, Honda retired. Successors adopted a more decentralized
decision system. Major decision-making authority was spread among nearly 30 senior executives, who spent much of their time gathered at conference tables hammering out policies in informal sessions called waigaya—a Honda word meaning “noisy-loud.” Engineers in research and development had significant control of the design of new automobiles. Under this so- called Honda System, the company grew and prospered.
By the late 1980s Honda’s growth had stalled and profits declined. Honda lost market share in the Japanese auto market, falling from third to fourth behind Mitsubishi, Nissan, and Toyota. Part of Honda’s problem was that it failed to respond to changing tastes in the Japanese auto market. Many Japanese consumers wanted to purchase sporty cars with distinctive styling, yet Honda concentrated on producing four-door family sedans.
Chapter 12 Decision Rights: The Level of Empowerment 377
In April 1991, the new CEO, Nubuhiko Kawamoto, announced that he was chang- ing the decision-making system at Honda by taking direct control of the company’s automotive operations in Japan. He reasoned that the company had grown too large for group decision making. To quote Kawamoto,
We’d get the people from research, sales, and production together and everyone would say “not this” or “not that.” We’d talk but there would be no agreement. Product planning would be on a tight schedule but we would have another discussion, another study and more preparation. Finally, the decision would come months later.
The centralization of decision rights at Honda was seen as a cultural revolution. Even after Kawamoto obtained the retired Honda’s support for this radical change, Honda employees resisted. Yet despite this resistance, the system was changed. In 1993, powerful “car czars” ran the development of new models, middle managers had clear job responsibilities, and according to some insiders, Kawamoto’s power ex- ceeded even that once held by Honda.
The first real test of the new management structure was the unveiling of the 1994 Ac- cord in fall 1993. The vehicle was priced competitively and was widely acclaimed a suc- cess. The Accord was named one of the Top 10 Cars of 1994 by Car and Driver maga- zine and Import Car of the Year by Motor Trend magazine. In 2007 Honda, led by CEO Takeo Fukui, reported profits of $5 billion on revenues of $94 billion for the fiscal year ending in March 2007. The Accord is manufactured in 10 countries in Asia, North America, and Latin America as well as in Japan, and it is sold in approximately 140 countries.
Honda is just one of many firms that changed the assignment of decision rights within their organizations in the 1990s. In contrast to Honda, many firms decentral- ized decision rights—for example, through empowering employees. An example, again from the automobile industry, is Fiat. In 1992, Fiat announced that it was de- centralizing certain decision rights, assigning them to the operating levels and reduc- ing management positions. Other firms that decentralized decision rights in the 1990s include General Electric, Motorola, and United Technologies to name but a few. A common action has been to decentralize decision rights to teams of employees rather than to individuals. The financial press is replete with stories about how companies have improved profits, quality, and customer satisfaction through employee empow- erment and other changes in their decision-making systems. Today we continue to observe successful firms that vary in their level of decentralization. Google is a prominent example of a successful firm with decentralized decision making in 2014. In contrast, prior to his death in 2011, Steve Jobs was critically involved in the devel- opment details of most of Apple Computer's highly successful new products.
These examples raise a number of important organizational questions:
• Can altering the assignment of decision rights really have an important impact on productivity and value?
• What factors affect the optimal allocation of decision rights within the firm?
• When is it optimal to delegate decision rights to a team of employees rather than to specific individuals?
The purpose of this chapter and the chapter that follows is to address these and re- lated questions. This chapter focuses on a single decision right and asks where that right should be located within the firm. The next chapter considers multiple decision rights and examines how combinations of rights are bundled into jobs and subunits (e.g., divisions) of the firm.
378 Part 3 Designing Organizational Architecture
This chapter begins by providing a detailed discussion of the problem of assigning tasks and decision rights within the firm. We then present a simple exam- ple that illustrates some of the important factors that determine the optimal assignment of a specific decision right—in this case, pricing a product. We use this example to discuss centralization versus decentralization, as well as the placement of a right among employees within the same hierarchical level. We also use this ex- ample as a springboard to discuss the trade-offs between assigning a decision right to an individual versus a team of individuals. Next, we consider the decision process in more detail and define the terms decision management and decision control, terms that are especially helpful in making the concept of empowerment more pre- cise. Finally, we examine how the incentives of employees trying to influence deci- sion makers can affect the optimal assignment of a decision right within the firm. The appendix to this chapter provides a more detailed analysis of some of the prob- lems that can arise in team decision making.
Assigning Tasks and Decision Rights Firms transform inputs into outputs, which are sold to customers. This process typi- cally involves many tasks. For example, at Honda Motor Company, vehicles have to be designed, assembled, sold, and delivered. An important element of organizational architecture is partitioning of the totality of tasks within the organization into smaller blocks and assigning them to specific individuals and/or groups.
Through the process of designing the organization, specific jobs are created. For example, if a set of clerical tasks is bundled together and assigned to an individual, a secretarial job might be created. Jobs have at least two important dimensions: The variety of tasks that the employee is asked to complete and the decision authority to determine when and how best to complete those tasks.
Jobs vary substantially in terms of the variety of tasks and scope of decision author- ity. Figure 12.1 depicts four possibilities. Point 1 displays a combination of few tasks and limited decision authority. An example is an office receptionist who concentrates
V a
ri e
ty o
f ta
sk s
Decision authority
1
2
3
4
Figure 12.1 Dimensions of Job Design
Two important dimensions of job design are the variety of tasks and scope of decision authority. This figure illustrates four possible combinations. Traditionally, many firms have created jobs like Point 1, which involve few tasks and limited decision authority. Lately, there has been a trend toward jobs like Point 4, which involve many tasks and broad decision authority. However, it is easy to give examples of jobs like Point 2, which involve many tasks and limited decision authority—for instance, certain clerical jobs. Similarly, it is easy to point to examples of jobs like Point 3, which involve few tasks and broad authority—for instance, certain sales jobs.
Chapter 12 Decision Rights: The Level of Empowerment 379
on a few tasks (answering the phone and taking messages) and has limited discretion as to what to do or how to do it. Point 2 shows a combination of many tasks and lim- ited decision authority. For instance, clerical jobs typically involve numerous tasks (fil- ing, word processing typing, answering the phone, and scheduling meetings, e.g.) but limited decision authority. Point 3 depicts a narrow set of tasks with broad decision au- thority. As an example, consider a sales representative who has broad decision rights concerning which customers to call, what sales pitch to make, what prices to charge, and so on. Yet the person concentrates on one principal task—selling products to cus- tomers. Recently, there has been a trend toward creating jobs like Point 4 that are less specialized and where employees have broader decision authority. Reasons for this trend will become evident as we proceed through the next two chapters.
As a manager moves up in the organization, these design issues consume larger amounts of the person’s time. For example, the manager of a purchasing department plays an important role in defining the tasks each employee within the department performs. Unfortunately, the problem of partitioning tasks into jobs is extremely complex. It involves the assignment of literally thousands of tasks and decision rights. It also involves simultaneous consideration of other corporate policies such as performance-evaluation and compensation policy—the other two legs of the organi- zational architecture stool. Although current theory is not sufficiently well developed to provide a detailed solution to this general problem, through some relatively sim- ple examples we can derive important insights. In this chapter, we present such an example to explore the issue of decision authority. The next chapter considers the problems of bundling tasks into jobs and jobs into subunits of the firm. Thus, this chapter concentrates on the horizontal axis in Figure 12.1 (decision authority), whereas the next chapter concentrates on the vertical axis (variety of tasks).
Our primary example in this chapter involves AutoMart, a firm selling automo- biles in two cities. As depicted in Figure 12.2, the management of the firm consists
Roberto Cruz CEO
Pekka Sahlstrom Local Manager
Colleen O’Hagan Local Manager
AutoMart Company
Figure 12.2 Organizational Structure of AutoMart Company
AutoMart markets automobiles in two cities. Roberto (Bob) Cruz is the CEO. The two local managers oversee the operations in the two cities. The one important decision right in this example is the pricing decision. The first question involves centralization versus decentralization. Should Bob make the pricing decisions or should they be decentralized to Colleen and Pekka? The second question involves horizontal placement of decentralized decision rights. If pricing decisions are decentralized, Bob could (1) grant each manager the pricing right for that manager’s own location, (2) grant both decision rights to one manager who would make all pricing decisions, or (3) grant the decision rights for the two locations to both managers and ask them to work as a team.
380 Part 3 Designing Organizational Architecture
of Roberto (Bob) Cruz, the CEO, and two local managers, Pekka Sahlstrom and Colleen O’Hagan. The local managers oversee the operations in the two cities. We concentrate on one specific task/decision right, pricing. Assigning an individual the right to set prices at a local unit increases that person’s decision authority. If Bob grants local managers the right to set prices, he reduces his decision authority and correspondingly increases the decision authority of the local managers. Ini- tially, we assume that either Bob sets the prices at the local units or he grants the right to set prices to the local managers. In reality, Bob can grant the local man- agers some decision authority without giving them full pricing rights. For exam- ple, Bob might allow the managers to set prices within a given range. We consider these additional possibilities later in this chapter.
The issue of centralization versus decentralization focuses on which level of the firm’s hierarchy to place the decision right. The firm is said to have centralized deci- sion making if the right is assigned to Bob and decentralized decision making if the right is assigned to the local managers. A second issue is choosing where within a given hierarchical level a decision should be made. The decision authority of both local managers is increased if both are given decision rights for pricing. Alterna- tively, Bob might decide to increase the decision authority of only one of the local managers—for example, by letting Colleen make all pricing decisions. We begin by discussing centralization versus decentralization. We subsequently consider the lat- eral issue of where across a hierarchy to place the right.
Centralization versus Decentralization Most of the analysis of assigning decision rights has focused on the question of whether to centralize or decentralize decision rights.2 We employ AutoMart to illus- trate the major implications of this analysis. The basic question is should Bob set the prices at the two locations or should the pricing decisions be decentralized to the local managers? The answer to this question depends on the benefits and costs of de- centralized decision making (relative to centralized decision making).
Benefits of Decentralization
Effective Use of Local Knowledge Local managers are likely to have important information about their local markets. For example, they are likely to have better information than Bob about the demands and price sensitivities of particular customers. They are also likely to know more about the quality and condition of their used cars. This information is potentially costly to transfer. If Bob makes all pricing decisions, the firm either incurs informa- tion transfer costs or bears the cost of making decisions absent relevant knowledge. Decentralizing decision rights links decision making authority with local specific knowledge and can reduce the costs of information transfer and processing. More effective use of local knowledge is thus one of the major benefits of decentralized decision making.
2For a technical discussion of these issues and a review of the associated literature, see P. Bolton and M.
Dewatripont (2012), “Authority in Organizations,” in R. Gibbons and J. Roberts (Eds.), The Handbook Of Organizational Economics (Princeton University Press, Princeton NJ), 342–372.
Chapter 12 Decision Rights: The Level of Empowerment 381
Centralized decisions require local managers to seek permission to change prices. Local information has to be transferred to Bob or be ignored. Subsequently, Bob has to deliberate and convey his decisions back to local managers for implementation. This process takes time, and decision making is slower as a result. Such delays can lead to lost sales. Granting decision rights to the local managers promotes more rapid decision making and quicker responses to changing market conditions.3
Conservation of Management Time If Bob makes local pricing decisions, substantial opportunity costs might be in- curred: Using top-management time for pricing decisions means that time cannot be used for other decisions. Often, it is better to decentralize operating decisions to local managers and focus senior managers’ attention on strategic decisions (e.g., which car lines to sell and how to promote them). As Alfred Sloan, former CEO of General Motors and an early proponent of decentralization, described,
My office force is small. That means we do not do much routine work with details. They never get up to us. I work fairly hard, but it is on the exceptions . . . not on routine or petty details.4
Training and Motivation for Local Managers It is important for firms to attract talented employees and to train them as eventual replacements for senior management. Decentralizing decision rights promotes both objectives. Granting responsibility helps attract and retain talented, ambitious local
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How Much Decentralization at Google? This chapter implies that there is an important role for managers in organizations. Completely decentralized decision
making would suffer from a wide range of incentive, coordination, and communication problems.
Google is staffed with many very smart software engineers. Historically, people at the company were skeptical that
managers added any value. Most of the software engineers wanted to spend their time on programming, not
communicating with managers. In 2002, the founders of Google experimented with a completely flat organization with
no managers. The experiment lasted but for a few months. Too much of the CEO’s time was spent dealing with the
many “nitty-gritty issues” that frequently arise with employees. The founders realized that managers contributed to the
company in many ways, for example, in fostering coordination and communication among employees and in helping to
assure proper incentive alignment.
Google, however, remains a highly decentralized company. As of 2013, it has over 37,000 employees with only
5,000 managers, 1,000 directors, and 100 vice presidents. It is common to find engineering managers with as many as
30 direct reports. According to a Google engineer, this is done by design to prevent micromanaging: “There is only so
much you can meddle when you have 30 people on a team, so you have to focus on creating the best environment for
engineers to make things happen.” Since the software engineers hold much of the specific knowledge, which Google
has used to create value, it makes economic sense for them to have more decentralized decision rights.
Source: D. Gavin (2013), “How Google Sold its Engineers on Management,” Harvard Business Review (December).
3In the Honda example, decentralized decision making was slower than centralized decision making.
However, in Honda’s case, decision rights were decentralized to a team of employees rather than to an
individual. Thus, the bottleneck was in the centralized coordination of the inputs from a number of team
members. Later in this chapter we discuss how team decision making can be time-consuming. 4A. (Sloan (1924)). “The Most Important Thing I Ever Learned about Management,” System–the Magazine of Business 44: p.137 (August).
382 Part 3 Designing Organizational Architecture
Communication within Firms To simplify the analysis, in this chapter we assume that one manager is better informed than the other and focus
primarily on how to assign decision rights. But in general, managers can have incentives to acquire information and to
intentionally distort their information before communicating it to other managers within the firm. An important line of
research on the internal organization of firms examines the more general problem of communications within firms and
the incentives to communicate honestly or to distort ones’ information.
Crawford and Sobel describe how a better informed agent has an incentive to distort his private information, that is,
communicated to the less informed principal who then uses the information to make a decision that affects each of their
welfares. Their model shows that the agent’s communication is inevitably distorted, and the agent introduces more
noise when the principal's and agent's objectives are less congruent. The key insight from Crawford and Sobel is that
communication from an agent to a principal invariably involves a loss of information, unless the agent’s and principal’s
interests are perfectly aligned.
Crawford and Sobel only study the incentive of the agent to distort private information. Dessein extends their model
by examining the relation between delegating decision rights to the agent and having the agent communicate his private
information to the principal. Dessein shows that a principal decentralizes decision making to the better-informed agent
rather than to communicate with this agent as long as the agent’s and principal’s interests are relatively aligned and the
principal’s uncertainty about the environment is not too great. In Dessein’s model, a principal often delegates decision
rights to avoid the inevitable noisy communication, and the resulting loss of information. The key insight provided by
Dessein is to highlight the central trade-off between a loss of control under decentralization and a loss of information
through communication.
Source: V. Crawford and J. Sobel (1982) “Strategic Information Transmission,” Econometrica 50, 1431–1451; and W. Dessein (2002) “Authority and Communication in Organizations,” Review of Economic Studies 69, 811–838. Also see, P. Bolton and M. Dewatripont (2013), “Authority in Organizations,” in R. Gibbons and J. Roberts (Eds.), The Handbook of Organizational Economics (Princeton University Press, Princeton NJ), pp. 342–372.
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managers who are likely to value this aspect of the job. It also provides experience in decision making that is important training for more senior positions. Finally, with the power to choose projects, lower-level managers can have stronger incentives to exert effort in finding, evaluating, and implementing new projects—decentralization in- creases the operating managers’ level of commitment to their projects.5
Costs of Decentralization
Incentive Problems Decentralizing decision rights marries authority with local specific knowledge. However, the local managers do not necessarily have strong incentives to act to max- imize a firm’s value. For example, the managers might sell cars to their friends at low prices or obtain kickbacks from customers in return for selling at low prices. Devel- oping an effective control system to motivate desired actions is not always easy or in- expensive. Also, there is a residual loss because it generally does not pay to resolve in- centive problems completely. Incentive problems usually are larger the lower in the organization decision rights are placed.6
5See P. Aghion and J. Tirole (1997) “Formal and Real Authority in Organizations,” Journal of Political Economy 105, 1–29.
6There are incentive problems even with centralized decision making—the decision maker is concerned that
employees might not follow orders. These incentive problems usually are less severe than the incentive
problems from decentralized decision making.
Chapter 12 Decision Rights: The Level of Empowerment 383
Another incentive problem of decentralization occurs when a manager deliber- ately recruits weaker subordinates or refrains from developing employees under them.7 Even though these behaviors reduce the performance of the manager’s unit, they can enhance the manager’s career because managers sometime view their sub- ordinates as threatening. For example, suppose Bob, Mary’s boss, has assigned the decision rights to Mary to hire her direct reports. Mary has an incentive to hire Phil, who is a weak employee relative to Mary. Bob may then view Mary as better suited for future job promotions than Phil. One way to counter this threat is by requiring communication about performance evaluations to pass through a “chain of command.” Communication makes it easier to replace unproductive managers. But
7G. Friebel and M. Raith (2004), “Abuse of Authority and Hierarchical Communication,” Rand Journal of Economics 35, 224–244.
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Decentralization Imposed Large Costs on General Motors General Motors (GM), like most very large corporations, must decentralize the vast majority of the decision rights to
lower-level managers. For example, take the decision that a lower-level GM manager made in 2004 when the ignition
switch for the new Chevrolet Cobalt did not meet GM’s original specification. This manager could have rejected the
switch manufactured by an outside supplier, which would delay production and sales of Cobalts. Or, this manager
could change the design specification so the faulty switch would pass. But accepting the lower quality switch could
impair the safety and reliability of Cobalts. The decision was made to “accept” the switch. This decision turned out to
be extremely costly.
If the driver bumped the key in the ignition or if the key chain was too heavy while the key was in the ignition, the
switch could turnoff the engine even though the car was in motion. Numerous accidents and some fatalities occurred,
leading to private law suits, regulatory investigations, and eventually U.S. Congressional hearings.
Lower-level GM managers decided against issuing a recall of vehicles, containing the faulty switch even though
GM had evidence of crashes and fatalities starting in 2004. The newly appointed CEO of GM, Mary Barra did not
learn of the faulty switch until January 2014. Not until February 2014 did GM officially recall vehicles containing the
faulty switch. In April 2014, Barra was called before the U.S. Senate and House of Representatives for two days to
answer blistering questions of why GM in the early 2000’s allowed a part that did not meet GM’s own technical
specification to be installed, and whether GM tried to cover-up Cobalt’s safety record.
The GM faulty ignition switch incident provides important lessons about the costs of decentralization. First, bad
news is less likely to be communicated up the chain of command. Communicating bad news can delay projects that can
hurt the bottom line. Lower-level managers, who often have the bad news and fear “shooting the messenger,” are often
reluctant to share it. Second, if good news is more likely communicated than bad news, senior managers can have an
overly optimistic view of the entire firm. Senior managers require full information to make informed decisions, but
what senior managers know depends on what gets communicated up the chain. And what gets communicated depends
on the incentives that senior managers implicitly or explicitly create for lower-level managers to communicate.
Finally, the problem of inducing lower-level managers to disclose their private good and bad news is further
complicated by the fact that this news often has implications about the sender’s performance. For example, the
manager of a project likely knows sooner than anyone else whether her project will succeed. She has incentive to delay
releasing news that her project will fail in hopes of being able to turn it around. On the other hand, she has incentive to
disclose favorable news that her project will succeed in hopes of getting additional resources to enhance the chance of
project success. Professor Bengt Holmstrom at MIT describes this incentive problem as, “a CEO needs to trust the
board enough to give directors information they ultimately could use to fire him.”
Source: A. Auriemma (2014) “Chiefs at Big Firms Often the Last to Know,” The Wall Street Journal (April 3), B1, and T. Basu (2014) “Timeline: A History Of GM’s Ignition Switch Defect,” (March 31), www.npr.org/2014/03/31/297158876/timeline-a-history-
of-gms-ignition-switch-defect
384 Part 3 Designing Organizational Architecture
M A N A G E R I A L A P P L I C AT I O N S
International Companies Blend Centralization and Decentralization Large multinational companies must understand the specific customs and tastes of customers in their local markets. For
example, P&G lost money in Europe when it tried to sell Secret solid stick and roll-on deodorant to a market accustomed
to aerosols. Germans tend to shop at discounters more than their American counterparts. Toothpaste is sold in supermarkets
and drugstores in the United States, but by law in some European countries toothpaste is only sold in drugstores.
Instead of standardizing their products across local markets, these large companies are adapting them to local tastes,
customs, and laws. Instead of transferring the specialized knowledge of local tastes, customs, and laws to corporate
headquarters, multinational firms hire local managers and decentralize decision rights to adapt the product to the local
markets. Siemens, the large German electronics and engineering conglomerate, does 80 percent of its sales outside
Germany. In most of these countries it employs local managers. But, decision rights over quality and values are
retained at the corporate level. UBS of Switzerland, the banking and financial services firm, closely monitors its
foreign operations, all of which carry the UBS name.
Source: C. Hymowitz (2003), “European Executives Give Some Advice on Crossing Borders,” The Wall Street Journal (December 2), B1.
this increases the manager’s propensity to hire less-competent workers. In some cases, it is best to limit communication.
Ideally, Bob would like to measure the effect of the local managers’ decisions on the value of the firm. If Bob could, it would be relatively easy to use compensation schemes to motivate value-maximizing behavior. Unfortunately, identifying the effect of individual decisions on the value of the firm usually is impossible. Compensation schemes can be based on performance measures such as internal accounting numbers. For example, the local managers might be paid based on total profits for their units. However, as we will discuss in Chapters 14 through 17, developing effective compen- sation schemes and performance measures is difficult. The firm can use other mechanisms—for example, direct monitoring—to reduce incentive problems, but none of these techniques is costless and none will resolve these problems completely.
Coordination Costs and Failures If the two local managers set prices independently, they might ignore important in- teraction effects. For instance, lowering the price in one city might divert sales from the other city, especially if they are nearby and share local media. It also might be wasteful for both managers to conduct the same type of market analysis to decide on their pricing policies if their markets are similar. For instance, most of the informa- tion might be obtained by conducting only one survey, or more precise estimates might be derived by pooling the data.
Less Effective Use of Central Information Local managers do not necessarily have all the relevant information to make good pricing decisions. Bob might have important information about product costs, up- coming promotions, and new products from the automobile manufacturer. Bob also might have important knowledge and expertise for solving pricing problems. Often, central managers obtain important information from observing the effects of various policies implemented through time and across multiple locations. In contrast, local managers generally have more limited experience and obtain direct information from only one location. And if industry conditions are such that rapid decision mak- ing involving central information is important, the benefits of centralization of deci- sion rights are even greater.
Chapter 12 Decision Rights: The Level of Empowerment 385
This discussion implies that an important role of central management in a decentral- ized decision system is to promote information flows and coordination among decision makers in the firm. These activities are likely to be costly. For instance, transferring in- formation to local decision makers can be expensive. The value of coordination and central information will be lower when the product demands and costs for the local units are more independent (e.g., the locations are further apart) and more of the rele- vant knowledge for decisions is held by the local managers. The benefits and costs of decentralized decision making are summarized in the accompanying chart.
Forgone Scale Economies Centralized decision making can sometimes be more cost effective than decentral- ized decision making due to scale economies. As an example, consider the decision rights to develop advertisements for a product that is marketed across several coun- tries. These decision rights could be decentralized to the country level. Each country would employ staff to develop, test and produce advertising for the product. A com- pany-wide advertising campaign, however, could be developed centrally with fewer staff and at lower cost.
Economies of scale are likely to be particularly relevant when local information is less important. In the preceding example, centralized decision making results in a co- ordinated ad campaign that is used across all countries, while decentralized decision making results in ads that are more effectively tailored to their local markets. Which option is better depends on the nature of the product and the characteristics of the local markets.
The Benefits and Costs of Decentralized Decision Making
Benefits Costs
More effective use of local knowledge Incentive problems Conservation of senior management time Coordination costs and failures Training and motivation for local managers Less effective use of central information
Forgone scale economies
Illustrating the Trade-offs
To illustrate the basic trade-offs in this example, assume that the pricing decision can be decentralized to the local managers in varying degrees. We use D to represent the degree of decentralization of the pricing decision. When D � 0, all pricing decisions are made by Bob; as D increases, the local managers are granted more decision rights. For example, at a low level of D, the managers might have the authority to alter centrally determined prices within a 5 percent band. At a sufficiently high D, the local managers have full authority to set prices. For simplicity, assume that D is con- tinuous. Also, suppose that the benefits of decentralization can be written as
Benefits � B � D (12.1)
where B is a positive constant. The benefits include better use of local knowledge, con- servation of senior management time, and training/motivation for local managers.
There are, however, costs associated with decentralization. For instance, there are increased incentive problems, and the decisions of the local managers have to be
386 Part 3 Designing Organizational Architecture
Theoretical Research in Economics of Decision Making Provides Useful Managerial Insights In this chapter we summarize the major costs and benefits of decentralized decision making, as suggested by the ever-
growing body of theoretical and empirical research on the internal organization of firms. This box summarizes several
important papers that provide useful insights on how various factors stressed in this chapter are likely to affect the
centralization–decentralization decision.
Consistent with the benefits and costs of decentralized decision making discussed in this chapter, Aghion and Tirole
present a formal model that stresses the importance of information and incentives in driving the
centralization–decentralization decision. In their model, there is a central manager (the principal/owner of the firm) and
a local manager (the agent). The firm faces a menu of potential investment projects. Initially, neither manager can
distinguish among the potential projects in terms of expected benefits. Both agree that without additional information, it
is better not to invest in any of the potential projects. Either party can privately choose to exert costly effort and become
fully informed about the projects, but the effort might fail. The preferences of the two managers, while not perfectly
aligned (there is an agency conflict), are partially congruent. With full information about the benefits of each project,
the managers would prefer different projects because of the “private benefits” they would receive. Each manager,
however, benefits to some degree from the other manager’s preferred project.
Initially, the central manager has the “formal authority” to make the decision, but this decision can be delegated to
the local manager. The benefit of delegating the formal authority to the local manager (decentralizing the decision right)
is that it provides greater incentives to the local manager to exert effort to become informed about the projects, since the
local manager benefits by choosing the project preferred most by that manager. This choice also benefits the central
manager to some degree. The cost to the central manager of delegating formal authority is that the central manager will
not be able to choose her most preferred project, should she become fully informed by exerting effort. Having delegated
formal authority, she has reduced incentives to exert effort in information acquisition. The central manager with formal
authority will transfer “real authority” to the local manager to make the decision should the central manager’s efforts in
information acquisition fail. The local manager with real authority will only choose to invest in a project if he has
successfully acquired the information. This investment benefits the central manager as well. The central manager’s
decision to retain or delegate formal authority (centralization vs. decentralization) depends on the congruence of the
two managers’ preferences (the incentive problem) and which manager has a relative advantage in information
acquisition (as in our discussion of more effective use of local knowledge). The Aghion and Tirole analysis helps
explain why some firms, such as British Petroleum and Johnson & Johnson, commit to lightly staff some of their
corporate headquarter functions as a way to empower local managers. For example, EMC, which dominates the data-
storage business with over $23 billion in revenue in 2013, is organized as “three federated businesses” with different
names. The company explicitly gives local managers a “significant degree of local autonomy” to develop new ways to
serve customers and to innovate. Their analysis also suggests a potential benefit of dispersed shareholders in large firms
who delegate much of the formal authority for decision making to boards of directors and senior managers. The
influential paper by Aghion and Tirole has motivated other economists to extend their line of inquiry.
Dessein and Santos study another aspect of decentralization—one which we have stressed in this chapter—
coordination costs. Large firms employ many managers. Each specializes in certain tasks to increase her productivity.
But such task specialization generates costs as the firm must communicate and coordinate the various tasks performed
by its managers. In quickly changing environments, individual managers must redefine their tasks and then coordinate
their new tasks with the other managers, but this increases communication costs. Under decentralization each manager
is more specialized and hence more productive (as in our discussion of more effective use of local knowledge), but the
firm incurs larger coordination and adaptation costs. Centralization allows better coordination and adaptation, but there
are lower returns to specialization. Dessein and Santos’ analysis suggests that firms facing volatile environments should
centralize to lower coordination and adaptation costs. Their model helps explain why disaster relief is best
accomplished by centralized organizations.
Source: P. Bolton and M. Dewatripont (2013), “Authority in Organizations,” in R. Gibbons and J. Roberts (Eds.), The Handbook of Or- ganizational Economics (Princeton University Press, Princeton NJ), 342–372; P. Aghion and J. Tirole (1997), “Formal and Real Author- ity in Organizations,” Journal of Political Economy 105, 1–29; W. Dessein and T. Santos (2006), “Adaptive Organizations,” Journal of Political Economy 114, 956–995; G. Friebel and M. Raith (2004), “Abuse of Authority and Hierarchical Communication,” Rand Journal of Economics 35, 224–244.
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Chapter 12 Decision Rights: The Level of Empowerment 387
coordinated. Also, there are the increased costs of having to transfer central infor- mation to local decision makers. Assume the costs of decentralization are
Costs � (A � D) � (C � D 2) (12.2)
where A and C are positive constants. The first term, AD, represents the contracting costs that arise from resolving the incentive problems of decentralization; the second term, CD, represents the coordination/central information costs. This formulation assumes that coordination/information costs increase at an increasing rate with decentralization.8 For example, it becomes more and more difficult to coordinate de- cisions as decision rights become more decentralized.
The objective of the firm is to choose D to maximize the net benefits, where
Net benefits � Benefits � Costs � BD � AD – CD 2 (12.3)
Figure 12.3 depicts the benefits and costs of decentralization. Net benefits are maximized where the vertical distance between the benefits and the costs is greatest. This condition occurs at
D* � (B � A)�2C (12.4)
$
Decentralization
D* D
Costs
Benefits
T o ta
l c o st
s a n d b
e n e fit
s (i n d
o lla
rs )
Figure 12.3 A Graphical Illustration of the Trade-offs between Centralization and Decentralization of Decision Making at AutoMart
In this example, the local managers have important specific knowledge, that is, valuable for decision making, and timeliness of response is important. The benefits of decentralization are given by Benefits � BD, where D is the level of decentralization of pricing decisions and B is a positive constant. These benefits include better use of local knowledge, increased response times, conservation of the time of senior management, and training/motivation for local managers. The costs are given by Costs � AD � CD2, where the first term, AD, represents the increased contracting costs from decentralization and the second term, CD2, represents the increased coordination costs (A and C are positive constants). The optimal level of decentralization is D* � (B � A)�2C. At this point, the marginal benefits and the marginal costs of decentralization are equal. (The slopes of the total benefit and cost curves are the same.)
8Coordination and central information costs do not have to be quadratic, and the other benefits and costs do
not have to be linear. We use these functional forms to produce convenient solutions in our example, but the
basic principles of our analysis do not depend on these simplifying assumptions.
388 Part 3 Designing Organizational Architecture
As is standard in problems of this type, D * is the level of decentralization at which the marginal benefits of decentralization equal the marginal costs.9 At this point, the additional benefits from more decentralized decision making just offset the addi- tional costs. (Note that at levels of decentralization below D *, a small increase in de- centralization would add more to benefits than to costs so net benefits would rise. Conversely, at levels above D*, a small increase would add more to costs than to ben- efits so net benefits would fall. Thus, the maximum net benefit occurs where the slopes of the cost and benefit curves are equal.)
Over time, it is likely that the costs and benefits of decentralization will change. For example, the importance of local knowledge can change with changes in com- petition in the industry or shifts in consumer demand. Also, the costs of transferring information and controlling incentive problems can fall due to new technologies (e.g., consider cell phones and network computers). Changes in the benefits of de- centralization can be represented by changes in B, the coefficient in the benefits equation. For example, if the importance of local knowledge increases with more global competition, B increases. Equation (12.4) and Figure 12.3 indicate that in- creases in B are associated with increases in the optimal amounts of decentralization. Changes in the contracting and coordination/information costs of decentralization can be represented by changes in A and C, respectively. Both Equation (12.4) and Figure 12.3 indicate that an increase in these costs is associated with a decrease in the optimal level of decentralization.
Our analysis of centralization versus decentralization can help us understand the changes in the assignment of decision rights at Honda in 1991. Recall that after Soichiro Honda retired in 1973, the relevant specific knowledge for decision making was spread among many executives, making the benefits of decentralization high. In the context of our example, Honda could be viewed during this period as operating with an appropriately high level of decentralization. By 1991, however, Honda had grown tremendously and consensus decision making no longer was effective. Also, Nubuhiko Kawamoto, the new CEO, had been a Honda engineer and had detailed specific knowl- edge about designing automobiles. Thus, the benefits of decentralization were smaller than in the past (when senior management possessed less of the relevant knowledge). In response to these changing conditions, Kawamoto decreased the level of decentral- ization. In the context of our example, there had been a reduction in the benefits of decentralization as well as an increase in the costs, resulting in a lower optimal level of decentralization.
Our graphical illustration simplifies the centralization/decentralization decision in many ways. For example, the analysis is much more complicated if the assignment of more than one decision right is considered. Also, the example takes the divisional structure of the firm as given (two operating divisions and a headquarters). More gen- erally, the unit structure is determined along with the assignment of decision rights. (We discuss this issue in the next chapter.) It is particularly important to emphasize
9Technical note: The solution to this maximization process can be obtained through elementary calculus.
Alternatively, Equation (12.3) is quadratic, and thus you can use the quadratic formula to solve for the roots of
the equation. The two roots, 0 and (B � A)�C, are where net benefits equal 0. The parabola is at a maximum midway between the two roots: (B � A)�2C. Note that the optimal point D * is where the vertical distance between the benefits and the costs is greatest. This point occurs where the slope of the benefit curve is equal to
the slope of the cost curve. The slope of the benefit curve is the marginal benefit, whereas the slope of the cost
curve is the marginal cost. Thus, the optimal point is where the marginal benefit of decentralization equals the
marginal cost.
that when a firm changes its decision system, it typically is necessary to make corresponding changes in other organizational features, such as the performance-eval- uation and reward systems. These aspects of organizational architecture are like three legs of a stool, and it is important to keep them in balance. It often is desirable to ac- company decentralization with an increased emphasis on performance and incentive compensation to motivate the empowered decision makers. Our illustration is incom- plete in that it does not incorporate simultaneous changes in these other organizational variables. Despite these limitations, the example highlights some of the important trade-offs in deciding on the degree of decentralization.
Management Implications
Our analysis indicates that decentralization involves both costs and benefits. These costs and benefits are likely to vary across firms and time. We now examine how the optimal level of decentralization is likely to vary across firms. We then discuss factors motivating recent trends toward decentralization within many firms.
Across Firms We have discussed how the firm’s business environment and strategy are major deter- minants of organizational architecture. We focused particular attention on three aspects of the environment: Technology, market conditions, and regulation. We expect
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Some Bureaucracy Can Be Good One of the benefits of decentralization is effective use of local knowledge that speeds up decision making. Highly
centralized companies have numerous layers of bureaucracy that make decision making slow. In highly competitive
and dynamic markets such as high-tech firms, layers of bureaucracy can cause firms to miss windows of opportunities.
For example, a Facebook company’s motto is “Move Fast and Break Things.” And when Larry Page took over as chief
executive of Google, he felt it had become overly bureaucratic and he wanted to regain “the nimbleness and soul and
passion and speed of a start-up.” But layers of bureaucracy, such as centralized human resources departments, can
cause delay and create inefficiency.
Decentralizing all decision making, including the human resource function, even in high-tech firms creates
problems. For instance, assigning decision rights for personnel tasks to lower level managers can encourage these
managers to hire and promote people just like them, a practice which can lead to discrimination law suits. Notably,
GitHub, a web service for sharing and collaborating on software code, has been accused by a female engineer of
fostering a culture of bullying and disrespect toward women. GitHub had decentralized many of the HR tasks to lower-
level employees and there was little corporate oversight.
Moreover, Silicon-Valley start-up firms with centralized human resource departments appear to outperform firms
using a decentralized model. One study of 200 of these firms found that nearly half of the companies decentralized
traditional human resource tasks to lower-level employees, and only 6.6 percent had the type of formal HR
departments typically found in other industries. However, those Silicon Valley start-ups with centralized HR
departments were nearly 40 percent less likely to fail than start-ups that decentralized HR, and nearly 40 percent more
likely to go public. This study suggests that there is an optimal amount of decentralization—complete decentralization
of human resource tasks is unlikely to maximize firm value.
Source: D. Leonhardt (2014), “Yes, Silicon Valley, Sometimes You Need More Bureaucracy,” New York Times (April 30), www.ny- times.com/2014/05/01/upshot/yes-silicon-valley-there-is-such-a-thing-as-not-enough-bureaucracy.html?_r=0
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that the net benefits of decentralization will be highest in rapidly evolving environ- ments. Within unregulated industries where market conditions and production tech- nologies frequently change, the timely use of local knowledge is likely to be particu- larly important. In more stable environments, companies can use centralized decision making and concentrate on gaining economies of scale through large-scale standard- ized production.
We expect that the benefits of decentralization are likely to increase as the firm en- ters more markets. If a firm offers a broad array of products, it is less likely that se- nior managers have the specific knowledge to select the most appropriate operating decisions across its various businesses. Although not always the case, decentraliza- tion frequently will be more important for firms following a strategy in which they develop differentiated products that command price premiums. Such a strategy re- quires effective use of information on customer demands and competitor offerings. Often, this information is held by people lower in the organization. With cost strate- gies that focus on low-cost production of standardized products, local knowledge normally is less important.
Another element of strategy is the degree of vertical integration; for instance, whether a manufacturing firm should make its own inputs or provide its own retail distribution and service network. In general, we expect that as the firm becomes larger, either through vertical integration or through geographic expansion, the ap- propriate level of decentralization will increase. As a firm’s size increases, more de- cisions have to be made. Time and mental-processing constraints simply will pre- clude central managers from making all major decisions.
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Decentralization and the Global Supply Chain As most toy sales are made during the Christmas holiday period, toy companies used to place their orders in January
and February, blindly betting on demand. By December they would have shortages or stockpiles of duds. One notable
underestimate involved Mighty Morphin Power Rangers in 1993. Demand was estimated to be 600,000, but they could
have sold 12 million. New technology and global supply markets are changing the toy business.
New toys arrive in major retailers during the spring and summer. Toy companies download the daily sales of their
toys at Walmart, Kmart, Toys “R” Us, and Target into computer models that update the projected Christmas demand
forecast based on how the toys are selling during the spring and summer. One educational toy sold 360 units during its
introductory weekend. Based on these numbers, the computer model doubled the toy’s sales projections to 700,000
units. But the factory in China was only told to produce 350,000 units, and was given 12 months to produce them. To
double output and do it in three months required more specialized tooling to produce all the plastic parts. Since the
Chinese factory had designed the tools to make the parts, they had their design team reengineer the tools so that more
parts could be made faster and with fewer defects, and the toys could be assembled faster. Because the Chinese factory
had experience producing the toy, they knew how to improve the toy’s design to reduce the defect rate from 5 percent
to 0.3 percent.
The Chinese toy factory is a 14-acre integrated design and production facility that specializes in supply-chain
efficiencies. Gaining access to real time sales data at the large retailers, toy companies are using this information to
generate more accurate forecasts of final demand. The decision rights to change production schedules are decentralized
lower in the toy companies. At the same time, the decision rights to change production designs are decentralized to
companies that have the specialized knowledge of how to make the toys faster and better.
Source: G. Fowler and J. Pereira (2003), “Behind Hit Toy, A Race to Tap Seasonal Surge,” The Wall Street Journal (December 18), A1, A12.
Centralized decision making has particular advantages when coordination of ac- tivities within the firm is important. For instance, hub-and-spoke airlines schedule flights from the spokes to arrive at roughly the same time at a central hub. Passengers connect to their next flights that leave later. Airlines using centralized scheduling are able to coordinate the flight schedules and arrange baggage connections at lower cost, offering greater convenience to customers, than if schedules were determined by multiple decentralized decision makers (e.g., the pilots).
Recent Trends In contrast to Honda, the general trend over the last two decades has been toward greater decentralization. We have suggested that changes in organizational architec- ture are motivated by changes in the basic economic environment. We now examine those factors which have changed in the environment to promote decentralization.
Over the past two decades, global competition has increased tremendously within many industries. Consider, as examples, the automobile, cellular devices, and com- puter industries. This competition has placed pressures on firms to cut costs, produce higher-quality products, and meet the demands of customers in a more timely fash- ion. The information for improving quality, customer service, and efficiency often is located lower in the organization. Thus, these competitive pressures have increased the benefits of decentralization for many firms.10
Technology has motivated changes in the level of decentralization for two reasons. First, the rate of technological innovation has increased dramatically. Firms must either respond quickly to the resulting changes in market conditions and production technologies or lose profits. This innovation can prompt firms to
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Centralizing R&D to Boost Return on Investment The large Swiss pharmaceutical company, Novartis, is seeing its profits erode. As its medicines lose patent protection,
less-expensive generics enter the market, thereby allowing health care providers to choose lower-cost drugs. This is
forcing Novartis to rethink its research-and-development strategies to channel resources to more-promising
experimental drugs and avoid others that might be tempting but more difficult to deliver. First, Novartis took the risky
step of raising its 2013 spending on in-house R&D by 5.6 percent to $9.85 billion. Second, it consolidated all of its
R&D activities into four cities: Shanghai, Basel, Boston, and La Jolla, California. By centralizing R&D into these four
locations, Novartis hopes to foster greater cooperation and interaction between researchers in different disciplines now
at the same location and to tap the academic communities of the four cities. The Novartis CEO explains, “a larger
group of people benefiting from the infrastructure that’s been created at a research place is a better approach than
having small groups with limited infrastructure spread around the world.”
Source: M. Falconi (2014), “Novartis Chairman Stresses Need for R&D Investment, The Wall Street Journal (March 22), www.wsj.com/news/articles/SB10001424052702303802104579453092985730948
10Foreign competition also has reduced the power of labor unions to enforce inefficient work rules
(e.g., contract restrictions limiting the tasks that specific employees can perform). When competition largely
was restricted to domestic, heavily unionized firms, there was limited pressure to change work assignments
and decision rights in American firms. Competition from more efficient foreign and nonunion competitors
altered this environment.
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decentralize decision rights when important aspects of the knowledge of new technologies are not held by the central corporate office. Second, new technologies have altered the costs of information transfer substantially (for instance, smart wire- less devices). In some cases, these changes have worked to promote decentraliza- tion. For example, advanced telecommunications systems (satellites, Wi-Fi, and fiber optics) have reduced the costs and time of transferring central information to local decision makers to coordinate and enhance decentralized decisions. This tech- nology has also made it less expensive to track the sales and production costs of in- dividual products. This reduction in costs has increased the feasibility of develop- ing more precise performance standards for local decision makers to use in incentive compensation plans.
In other cases, the effect has been in the opposite direction: Local information has become less expensive to transfer to central headquarters, thus favoring more cen- tralized decision making. For example, supermarket electronic scan lines allow central tracking of inventory and can increase the benefits of centralized purchasing.
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Decentralizing Decision Making to Computer Models Many websites such as those for Amazon, Best Buy, United Airlines, Marriott, and Home Depot use dynamic pricing
models to change the price of their goods or services frequently using complicated computer algorithms. For example,
Amazon changed the price of a GE microwave oven nine times in one day, with the price fluctuating between $744.46
and $871.49. Best Buy’s computer responded by lifting its online price on the oven to $899.99 from $809.99 after the
Amazon prices rose, then lowering it again after Amazon dropped the price. These algorithms use data on consumer
demand, competitors’ prices, and even the time of day and weather conditions to update prices. Some Internet retailers
try to maintain the lowest price, even by a penny, so their products are listed at the top of the search results when
shoppers do price comparisons. Banks approve loans using computer models that incorporate up-to-date information
on borrowers’ payments on credit cards. These computer models are just one example of using computer models to
make decisions that were once made by people.
Human decision making is limited by the quantity of data one person can assemble and process. Human decisions
can be slow, biased, and unreliable. Computer models can process vast amounts of data, consistently, and quickly. They
work 24/7, and do not require expensive control systems to resolve agency problems. Moreover, they can be
programmed to learn from their mistakes. Chess-playing computer models can beat even the best grand masters.
Computer models work best where the decision can be quantified, such as prices, there is an abundant amount of data,
the decision must be made relatively frequently, and the underlying relations are stable.
But computer decision models can lead to problems. Amazon faced a fire storm after some customers who bought
DVD movies began comparing notes online and learned they had been charged different prices for the same DVD. It
turns out that Amazon had been conducting random pricing tests to determine the profit-maximizing price point that
balanced profit margin and sales volume. The media picked up the story and Amazon ended up refunding 6,896
customers an average of $3.10 each, or a total of $21,377.60. Vast Internet databases allow pricing models to charge
different prices based on individuals’ billing information, purchasing history, zip codes, and other demographic data.
Undoubtedly, this will create a demand for new websites that facilitate users fooling the models at other websites to
“think” the consumer should be offered a lower price.
Sources: J. Angwin and D. Mattioli (2012), “Coming Soon: Toilet Paper Priced Like Airline Tickets,” The Wall Street Journal (September 5), www.wsj.com/news/articles/SB1000087239639044 4914904577617333130724846; A. Nusca (2013), “The future of
retail is dynamic pricing. So why can't we get it right?” ZDNet (October 2), www.zdnet.com/the-future-of-retail-is-dynamic-pricing- so-why-cant-we-get-it-right-7000021444/; and M. Martinez (2013), “Amazon Error May End ‘Dynamic Pricing,’” (September 29),
abcnews.go.com/Technology/story?id=119399.
Many of the restocking decisions within Walmart now are handled by an automated system through which suppliers restock items at individual stores whenever the computer system indicates that inventories have fallen to a specified level. Managers at individual stores have few decision rights over inventory levels.
Technological advances also have allowed many firms to flatten their management structures. Traditionally, firms have relied on middle managers to transmit information and instructions from senior management to lower-level employees. Middle managers also have played an important role in coordinating and monitoring the actions of these lower-level employees. Cloud-based technology, by facilitating communication be- tween senior management and lower-level employees, has reduced demands for mid- dle managers. Technology also has motivated changes in the roles of middle man- agers. In many firms middle management’s role has shifted from being a conduit in the information flow to one that more closely resembles the coach of a sports team—as- sembling the optimal set of players, helping them design winning strategies, providing motivation, and so on.
Lateral Decision-Right Assignment Although discussion of decision rights often focuses on centralization versus decen- tralization, lateral issues also can be important. In our AutoMart example, if Bob de- centralizes decision rights, he can
• Grant the two managers the pricing decisions for their own locations, or
• Grant both decision rights to one manager who makes all pricing decisions, or
• Grant the decision rights for pricing at the two locations to both managers and ask them to work as a team in deciding on the pricing policy.
As in the centralization versus decentralization problem, the relevant factors in making this choice include the distribution of knowledge and the costs of coordina- tion and control. For example, granting decision rights to the managers separately takes greater advantage of local specific knowledge. But pricing at the two locations will not necessarily be well coordinated. Alternatively, granting all decision rights to one manager promotes coordinated decision making and takes advantage of any economies of scale in having one person make both decisions. But it comes at the po- tential expense of less effective utilization of the other manager’s local knowledge. There also might be differences in contracting costs between these two alternatives. For example, it might be less expensive to monitor the decisions of one person than two. The value of the third option, granting decision rights to a team of managers, de- pends on a number of factors that we discuss in the next section. Which of the three options is best depends on the specific circumstances facing the firm. For instance, having the two managers make independent decisions is likely to dominate when the two markets are more independent and more of the relevant knowledge for pricing is at the individual unit level.
Questions relating to the lateral placement of decision rights frequently arise within organizations. For example, should personnel decisions be made within each individual division, or should these rights be granted to a separate human resources department? Should a divisional manager be in charge of R&D, or should this func- tion be centralized elsewhere within the organization? Can the college or business operate its own career services center, or must it rely on centralized career services of the university?
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Assigning Decision Rights to Teams Our analysis of AutoMart suggests that a firm might want to assign a decision right to a team of employees rather than to one individual. In this discussion, we use the term team to refer broadly to the many different types of work groups that have decision- making authority (teams, committees, task forces, and so on); for our purposes, more refined definitions are unnecessary. Firms grant decision rights to teams of employees for at least three basic purposes: To manage activities, to make products, and to rec- ommend actions. Teams that manage activities often are composed of individuals from different functional areas (e.g., marketing and finance). Teams that make prod- ucts generally are located at the plant level. For instance, some firms have granted to teams of production employees the decision rights to set their own work schedules and assignments and to organize the basic production process. Both types of teams tend to be reasonably permanent. The assignment is to manage some particular busi- ness or process. Teams that recommend actions focus on specific projects and nor- mally disband when the task is complete. We now discuss the benefits and costs of group decision making relative to assigning the decision right to a single individual.
Benefits of Team Decision Making
Improved Use of Dispersed Specific Knowledge The relevant specific knowledge for decision making often is dispersed among many people within an organization. For instance, the relevant knowledge for designing new products often is held by a variety of employees, including scientists, engineers, and sales personnel. Through the use of teams, those individuals with specific knowledge are involved directly in the decision-making process. By definition, specific knowl- edge is expensive to assemble and transfer to a single decision maker. Also, it can be important for the individuals with the relevant knowledge to share information among themselves. By sharing information in a group setting, new ideas might be generated that would not occur in a sequence of bilateral communications between a central decision maker and each of the individuals. By sharing information, employ- ees also become better informed for future decisions and actions. Granting decision rights to a team encourages the members to communicate and to brainstorm. Final decisions are made through consensus or some type of voting mechanism.
Employee Buy-In Employees often are suspicious that management-initiated decisions benefit man- agers at the expense of other employees; managers frequently suggest that they grant
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Employing Teams to Assemble Knowledge The board of directors at Home Properties (a real estate investment trust) decided to change the process by which
it approves acquisitions that arise between regularly scheduled board meetings. Acquisitions valued below $70 million
had been approved by use of a mail ballot. But board members became concerned that this process limited potentially
valuable discussions among the members of the board. A property committee was established consisting of those
outside board members with the most extensive real estate experience. All but the smallest acquisitions now are vetted
by this group prior to presentation to the full board for approval by mail. (Larger acquisitions still must be approved at
a formal board meeting.)
decision rights to groups of employees specifically to increase employee “buy-in.” It is asserted that employees who take part in a decision process are more likely to sup- port the final decision and be more active in its implementation. This occurs for at least three reasons: First, asymmetric information and uncertainty, in turn, prevent employees from knowing the full consequences of a decision. Second, a group of employees has less to fear if they make the decision themselves or if the decision is made by employees with similar interests (see also Web Chapter 20, available via Connect). Reduced concerns about the effects of the decision increase employee buy-in, even when the same decision might have been made by the central manager. Third, employees have stronger incentives to invest in implementing decisions that they recommend because their reputations depend on the ultimate outcomes of the decisions.
Costs of Team Decision Making
Collective-Action Problems Collective decision making often is slower. Recall how senior executives at Honda Motor Company took months to reach a consensus on policy decisions. Also, group decisions are not always efficient or rational.11 (Consider the old saying that a camel is a horse designed by a committee.) Group decision making also can be subject to manipulation and political influence. In the appendix to this chapter, we illustrate how the common decision rule of majority voting can be subject to manipulation; management implications of this analysis are highlighted.
Free-Rider Problems Team members bear the full costs of their individual efforts but share the gains that ac- crue to the team. This arrangement encourages team members to free-ride on the ef- forts of others (see Chapter 10). As we discuss in subsequent chapters, free-rider prob- lems can be reduced through appropriate performance-evaluation and reward schemes. However, these schemes are costly to design and administer.
Management Implications
When Will Team Decision Making Work Best? Some managers and consultants suggest that team decision making is virtually al- ways better than individual decision making.12 Our discussion indicates that this suggestion is not correct. Team decision making is more likely to be productive in environments where the relevant specific knowledge for the decision is dispersed among individuals and where the costs of collective decision making and controlling free-rider problems are lower.
Team decision making is a common component of total quality management pro- grams. Many firms have increased their use of team decision making in the last few years through the implementation of Total Quality Management or Six Sigma programs. Yet experience indicates that the indiscriminate use of teams in these programs can be counterproductive—in such cases, the costs exceed the benefits.
11K. Arrow (1963), Social Choice and Individual Values ( John Wiley & Sons: New York). 12For example, http://humanresources.about.com/od/teambuildingfaqs/f/optimum-team-size.htm
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Optimal Team Size Increasing the size of the team enhances the knowledge base of the team. However, it also increases the incentives to free-ride, as well as other costs associated with col- lective decision making. For instance, as team size grows, it can become difficult to make decisions and work in a coordinated fashion. Team size is optimal at the point where the additional costs of adding a new member equal the incremental benefits. Consultants argue that virtually all effective teams have no more than 12 members and most were much smaller (ranging from 5 to 7).
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Highly Decentralized Cargill Uses Teams at the Top Cargill, a $140 billion global producer and marketer of food, agricultural, financial, and industrial products and services,
employs 143,000 people in 67 countries. With over 70 decentralized business units, the CEO keeps his top team small.
The senior governing body, the Cargill Leadership Team, consists of six people. This team allocates human and financial
capital and sets the broad strategy, messaging, and tone. Below these six people is the Corporate Center, which includes
CLT members and about 25 others who serve as functional and platform leaders, the latter monitor the 70 business units.
Cargill’s Corporate Center is organized around 12 teams, such as the corporate food risk committee, the technology
committee, the strategy and capital committee, and the Cargill brand reputation committee. These teams determine
overall company policy and direction. The CEO states, “by keeping the CLT too small to conduct the day-to-day affairs
of the company, it forces that accountability and ownership down the line. The role of the CLT is ‘to put our noses in
and keep our fingers out.’ That’s the right way to run a company this size.”
Source: www.cargill.com; and G. Neilson and J. Wulf (2012), “How Many Direct Reports?” Harvard Business Review (April), Reprint R1204H.
ANALYZING MANAGERIAL DECISIONS: Teams at Nucor versus Levi Strauss
Nucor, the largest global steel joist and deck manu-
facturer and the biggest steel producer in the United
States, had sales in 2013 of $19 billion. Under team-
based production, each employee is assigned to a
team, and each employee is evaluated and compen-
sated based on the productivity of their team.
Nucor uses production teams of 12–20 people,
and ties pay directly to the amount of quality steel
produced each day. Its bonus system compensates
teammates for improving the process including
safely delivering quality product and operating
more efficiently. Teammates receive an hourly rate
or base salary for hours worked plus bonus and
profit sharing. Bonuses are paid weekly based on
each team’s production. At the end of each year,
employees receive profit sharing of 10 percent of
company earnings. A typical Nucor steelworker can
earn upwards of $90,000 per year. Nucor boasts of
low employee turnover of 7 percent per year.
Levi Strauss adopted team-based production
processes at its existing plants. Employees who had
been previously paid on a piece-rate basis were put
on a team-based process.
1. In general, what are the advantages and
disadvantages of team-based processes?
2. Team-based production at the nucor is widely
regarded as a success. By contrast, the Levi
Strauss team-based initiative is widely
regarded as a failure. Worker productivity
has declined and employee morale is low.
What factors caused the Nucor team-based
production to be a success and the Levi Strauss
experiment to be a failure? Why?
Source: M. Bolch (2007), “Rewarding the Team,” HR Magazine (Febraury 2); and www.nucor.com
Decision Management and Control13
Thus far, our characterization of decision making has been rather simplified. In par- ticular, we generally have assumed that an employee either has a decision right or does not. In reality, some aspects of a decision can be decentralized whereas others can be maintained at a higher level. For example, at AutoMart, the managers might be granted the right to set prices within some range but have to obtain approval from Bob for larger price changes. Thus, the decision authority of an employee can be in- creased (see Figure 12.1) without granting the employee all rights to a particular decision.
A useful characterization divides the decision-making process into four steps:
• Initiation. Generation of proposals for resource utilization and structuring of contracts
• Ratification. Choice of the decision initiatives to be implemented • Implementation. Execution of ratified decisions • Monitoring. Measurement of the performance of decision mak-
ers and implementation of rewards
Often, firms assign initiation and implementation rights to the same employees. Fama and Jensen refer to these functions as decision management; they use the term decision control to refer to the ratification and monitoring functions.
Employees normally do not bear the full wealth effects of their actions—there are incentive problems. Granting an employee decision management and decision control rights for the same decision typically will lead to dysfunctional behavior. In the case of AutoMart, if the local managers make pricing decisions and there is
no monitoring or other control, the managers are more likely to use the decision rights for their own benefit. For instance, the managers might sell cars to family and friends below cost. Whenever decision makers are not owners, separating decision management and decision control limits conflicts of interest. Only when the decision maker also is the major residual claimant—the person with the legal rights to the profits of the enterprise once all the other claimants of the firm (e.g., bondholders and employees) are paid— does it make sense to combine decision management and control.
Separation of Decision Management and Control A prominent example of separating decision management and decision control is the presence of a board of directors at the top of all corporations. In large corpora- tions, the residual claimants are shareholders. The management of the firm is largely the responsibility of the CEO, who typically owns less than 1 percent of the firm’s stock. To mitigate potential incentive problems, shareholders grant major
13This section draws on E. Fama and M. Jensen (1983), “Separation of Ownership and Control,” Journal of Law & Economics 26, 301–326.
Definition Decision management: The initia- tion and implementation of decisions. Decision control: The ratification and monitoring of decisions.
Basic Principle: Allocating Decision Rights If decision makers do not bear the major wealth effects of their deci- sions, decision management and decision control will be held by separate decision makers.
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decision-control rights to the board of directors. The board ratifies major decisions initiated by the CEO. The board also has monitoring authority and the rights to fire and compensate the CEO. However, since board members often are not major shareholders, there still is a role for other parties to “monitor the monitor.” This role is performed by large blockholders (such as public pension funds) and takeover spe- cialists. If board members do a poor job, they can be replaced through a proxy fight or corporate takeover.
The principle of separation of decision management and control helps explain the widespread use of hierarchies within organizations. In hierarchies, decision management is formally separate from decision control—that is, decisions of indi- viduals are monitored and ratified by individuals who are above them in the hierar- chy. The same employee might have both decision-control and decision-manage- ment functions. For example, divisional managers might have approval rights over certain initiatives of lower-level employees while at the same time have to request authorization for the division’s capital expenditure plan. The important thing is that one employee not have both the decision management and decision control rights for the same decision. In smaller organizations, where one person (or a small num- ber) has the relevant knowledge to make decisions, it is expensive to separate deci- sion management from decision control. In this case, the two functions often are combined. In such cases the decision maker also tends to be the major residual claimant to avoid incentive problems. (For example, the company is organized as a sole proprietorship, partnership, or corporation where the managers own much of the stock.)
Although management and control rights for a decision often are granted to indi- viduals at different levels in the organization, they sometimes are granted to separate individuals at the same level of the corporate hierarchy. For example, the quality of the output of a manufacturing division sometimes is monitored by a quality unit with equal status within the organization. Similarly, internal auditors often monitor units at the same hierarchical level.
Empowerment The concepts of decision management and decision control also are useful in mak- ing the term empowerment more precise. Managers sometimes are unclear about what rights are being granted when they announce that they are empowering em- ployees. This ambiguity can lead to disputes and conflicts between management and employees—for example, when management reverses the decisions of em- ployees who thought they were empowered. The principle of separation of deci- sion management and control suggests that empowerment should not mean that an employee has all rights to a particular decision. An empowered employee might have explicit rights to initiate and implement decisions; however, there is still an important role for managers to ratify and monitor decisions. Ratification does not necessarily mean that an employee must seek approval for every decision. In some cases, managers might want to preratify decisions within a particular range— boundary setting. For instance, we discussed how the managers at AutoMart might be given authority to set prices within some range. In any case, Bob would want to maintain monitoring rights over the decision. Often, conflicts over empowerment can be avoided by clearly delineating what rights actually are delegated to the employee.
Decision-Right Assignment and Knowledge Creation Much of our discussion thus far has focused on how to assign decision rights given the existing distribution of knowledge. As we have discussed, a potentially important benefit of decentralization is that it provides employees with the opportunity to act on their specific knowledge. However this is only part of the potential benefits of de- centralization: An important facet of the optimal assignment of decision rights in- volves the firm’s ability to create new knowledge. If the firm can identify employees who make particularly productive use of their specific knowledge and they can gen- eralize from that experience to produce new methods or procedures that can be trans- ferred to other employees, the productivity of a larger group within the firm can be increased.
We have discussed how value is created when wetware is converted into software. This process requires that employees be encouraged to experiment; successful experi- ments be identified; and reasons for their success be understood, codified, and imple- mented by others within the firm. Critical decision-control function for management within a decentralized organization is monitoring to identify superior performance. Therefore, one important function of the firm’s performance-evaluation system is to identify excellence.
Note that this function does not have to be performed by managers at higher lev- els within the organization. For example, Home Properties is a real estate invest- ment trust that owns and manages apartment communities. A critical responsibility
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Failure to Separate Decision Management from Decision Control at JP Morgan— The Case of the London Whale A fundamental principle in allocating decision rights is to separate Decision Management (initiation and
implementation) from Decision Control (ratification and monitoring) unless the decision maker also owns the firm.
Large financial institutions, including AIG, Merrill Lynch, and Société Générale, suffered substantial losses during the
2007–2008 financial crisis, arguably due in part to poor decision controls and monitoring of their traders. JP Morgan
(JPM) emerged from this crisis with its reputation for strong risk management and controls largely intact. Its CEO,
Jamie Dimon, was viewed as the “star” bank CEO in many circles.
In April 2012, the Wall Street Journal begin a series of articles on the “London Whale,” whose huge trading losses
significantly damaged JPM ‘s reputation for risk management. The London Whale was the name given to a JPM trader
who had taken very large, risky positions in collateralized debt securities. As losses from his positions began to appear,
JPM’s Dimon characterized them as a “Tempest in a Teapot”—words he would quickly regret. On May 10th, JPM
announced a loss of about $2 billion due to the Whale’s trading (this loss later grew to over $4 billion). By then Dimon
realized that the losses and damage to JPM’s reputation were huge. He said the problem was the result of “the bank’s
own errors.” In describing these errors he used strong words including, “flawed,” “complex,” “poorly reviewed,”
“poorly executed,” “poorly monitored,” and “self-inflicted.”
In September 12, 2013, JPM announced a combination of actions that were directed toward further separating
decision management and decision control for their trading activities. Among these, JPM budgeted an additional
$4 billion and committed 5,000 extra employees to increase trading controls. JPM also granted greater authority to
executives in charge of risk, legal, and compliance, which means they can no longer be overruled by business heads.
Source: M. Langley and D. Fitzpatrick (2013), “Embattled J.P. Morgan Bulks Up Oversight,” The Wall Street Journal (September 13).
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of the training department is to identify whether solutions to property management problems developed at one location can be applied to other properties. Training evaluates the knowledge generated in the wetware of individual employees and whether that wetware can be transformed into software that can be employed more widely within the organization. On the Home Properties organizational chart, train- ing and property management are at similar levels; this responsibility to create soft- ware thus represents a lateral, rather than hierarchical, assignment of responsibil- ity. Another frequently employed technique to identify more productive procedures is to form teams of employees. As Parsons notes, records from the productivity studies at Western Electric’s Hawthorne plant indicate that the workers regularly experimented with different procedures for assembling switches, monitored their resulting productivity changes, and encouraged coworkers to adopt efficiency en- hancing innovations (see Chapter 1). In this case, the responsibility was assigned to a team. Through such processes, the knowledge embedded in the wetware of indi- vidual employees is transformed into software that can be used more widely within the organization.
M A N A G E R I A L A P P L I C AT I O N S
Should CEO and Board Chair Be Separate? Many commentators complain that boards of directors of U.S. companies fail to provide adequate discipline of senior
managers. Of particular concern is the common practice of combining the titles of CEO and chair of the board. On the
surface, this practice seems to violate the principle of separating decision management and decision control. Benjamin
Rosen, chairman of Compaq Computer, voiced this concern succinctly:
When the CEO is also Chairman, management has de facto control. Yet the board is supposed to be in charge of management. Checks and balances have been thrown to the wind.*
Large shareholder associations and pension funds in recent years have sponsored proposals at Sears, Roebuck and
other large firms calling for separation of the titles. Government officials have considered regulations to force this
change.
Contrary to the allegations of reformers, combining the CEO and chair titles does not necessarily violate the
principle of separation of decision management and decision control. The extreme case of no separation exists only
when the CEO is the board’s sole member. Indeed, the boards of several large U.S. companies, including Dow, Ford,
Mattel, Monsanto, Warnaco, and Xerox, have dismissed their CEOs/chair since 2000.
Estimates indicate that the titles are combined in over 80 percent of U.S. firms. In the vast majority of the
remaining cases, the chair is the former CEO. Typically, when a new CEO is appointed, the old CEO/chair retains
the position as board chair for a probationary period. With acceptable performance, the new CEO also receives the
title of board chair and the old chair often retires. Proponents of regulations to force firms to appoint outsiders as
chair essentially argue that almost all major firms in the United States are inefficiently organized. Although this
assumption might be correct, reformers have presented no cogent argument for how such an important corporate
control practice can be wealth-decreasing and still survive in the competitive marketplace for so long across so many
companies.
While regulators have stopped short of a mandated board leadership structure, the Dodd-Frank Act of 2010 requires
publicly traded companies to disclose whether and why they chose to combine or maintain separate positions for the
CEO and Chairman. The SEC has mandated a similar disclosure requirement since December 2009.
*USA Today (April 22, 1993).
Source: J. Brickley, J. Coles, and G. Jarrell (1997), “Leadership Structure: Separating the CEO and Chairman of the Board,” Journal of Corporate Finance 3, 189–220.
Influence Costs14
To this point, we have assumed that decision-making authority is granted either to an individual or to a team within the firm. Once the right is granted, the employee or team is involved actively in decision making (subject to ratification and monitoring from others). Sometimes, firms use bureaucratic rules that purposely limit active de- cision making. For example, airlines allocate routes to flight attendants based on seniority—there is no supervisor who decides who gets which route. Similarly, some firms base promotions solely on years worked with the firm. Some universities pro- hibit grade changes once the grade is recorded.
One potential benefit of limiting discretion in making decisions is that it reduces the resources consumed by individuals trying to influence decisions. Employees often are quite concerned about the personal effects of decisions made within the firm. For example, flight attendants care deeply about which routes they fly. Em- ployees are not indifferent to which colleagues are laid off in an economic down- turn. These concerns motivate politicking and other potentially nonproductive influence activities. For instance, employees might waste valuable time trying to influence decision makers. In vying for promotions, employees might take dys- functional actions to make other employees look bad.
Not assigning the decision right to a specific individual lowers influence costs— there is no one to lobby. But such a policy can impose costs on an organization. Consider individuals who are competing for a promotion. These individuals have
14This section draws on P. Milgrom (1988), “Employment Contracts, Influence Activities and Efficient
Organization Design,” Journal of Political Economy 96, 42–60.
Separate Decision Management and Control—Not a New Idea The English merchant guilds were formed during the 12th century. These precursors to the modern corporation were
chartered by the crown and given a monopoly to conduct trade within their own towns, usually in return for a payment to the
crown. Each guild would specialize in a particular trade (carpenters, stone cutters, pewterers, etc.). The guilds held property
and elected officials to manage the trade and property. Incorporation by the crown created a legal entity that could conduct
business.
To protect the members of the guild from embezzlement and mismanagement by their elected officers, charters of
the guilds contained provisions for election of auditors from the general membership to audit the financial records of
the guild. For example, The Worshipful Company of Pewterers of the City of London was audited by its members. The
Book of Ordinances of 1564 contains the following “order for ye audytors”:
Also it is agreed that there shalbe foure Awdytours Chosen euery yeare to awdit the Craft accompte and they to parvese it and search it that it shall be perfect. And also to accompt it Correct it and allowe it So that they make an ende of the awdet therof between Mighelmas and Christmas yearely and if defaute made of ffenishings thereof before Christmas yearly euery one of the saide Awdytours shall paye to the Craft box vj s. viij d. pece.
Audits by members of the guild are early examples of separating decision management from control. The guild
officers had decision management rights, but decision control rights in the form of annual monitoring of financial
transactions were vested in member auditors.
Source: E. Boyd (1968), “History of Auditing,” in R. Brown (Ed.), History of Accounting and Accountants (A.M. Kelley: New York), 79; and R. Watts and J. Zimmerman (1983), “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence,” Journal of Law & Economics 26, 613–633.
H I S T O R I C A L A P P L I C AT I O N S
Chapter 12 Decision Rights: The Level of Empowerment 401
402 Part 3 Designing Organizational Architecture
incentives to provide evidence to their supervisor that they are the most qualified for the promotion. This information often is useful in making better promotion deci- sions. However, this information comes at a cost: Employees spend time trying to convince their supervisor that they are the most qualified rather than focusing on other activities such as selling products. It makes sense to run a “horse race” so long as the incremental benefits from better information are greater than the incremental costs of the influence activity. But the race should be stopped at the point where the value of the additional information about individual qualifications is equal to the cost of the additional influencing activity.
In some cases, the firm’s profits largely are unaffected by decisions that have an enormous impact on individual employee welfare. For example, United Airlines assigns flight attendants to routes using the following procedure: Once a month, the attendants request the routes they prefer, with conflicts resolved strictly on the
ANALYZING MANAGERIAL DECISIONS: Medford University
Medford University is a research university with
about 10,000 students. It has a good liberal arts
undergraduate program, a top-rated medical school,
and a fine law school. It employs about 12,000
people. A majority of these employees work at the
university hospital. Lately, the university has faced
significant financial pressures. It is in intense
competition for quality students with other col-
leges. Recent financial donations have been small.
The hospital is under intense pressure to reduce
costs because of changing health care regulation
and insurance coverage.
The university currently spends about $100 mil-
lion annually on fringe benefits (health insurance,
retirement plans, and so on). It also faces large fu-
ture payments of promised medical benefits to cur-
rent and future retirees. The president of the uni-
versity, Hiromi Kobayashi, has appointed a task
force to design a new fringe benefit package. The
task force consists of faculty and staff from depart-
ments throughout the university. The task force has
been asked to consider the university’s tenuous fi-
nancial condition. President Kobayashi wants to
reduce expenditures on fringe benefits (while
maintaining the quality of the faculty and staff).
The president has appointed the chief administra-
tor of the hospital as the chair of the task force.
The president also has appointed one of her key
assistants, the vice provost, to serve as secretary of
the task force (to take minutes and coordinate
meeting schedules).
1. Why did President Kobayashi appoint a task
force to consider the issue of fringe benefits?
She could have asked the university’s human
resources department to design a plan.
2. Should the president anticipate that all mem-
bers of the task force will strive to cut
university expenses? What actions can the
president take to increase the likelihood that
the task force members have this objective as a
major priority?
3. Why did the president appoint the administra-
tor of the hospital as the chair of the task
force? The chair, in turn, has delegated much
of the work to subcommittees (a health insur-
ance committee, a retirement committee, and
so on). What advice would you offer the chair
in appointing subcommittee chairs? Explain.
4. Does the president want to commit to accepting
the committee report or does she want to re-
serve the right to make modifications? Explain.
5. Why did the president appoint a key assistant
as secretary of the task force?
More complete answers to these questions can be developed by incorporating the material in the appendix to this chapter.
basis of seniority. United’s profits are virtually unaffected by which flight attendant gets the Hawaii route versus the Sioux Falls run. It is in such settings that bureaucratic rules for decision making are most likely. The firm benefits from a re- duction in influence costs but is little affected by the particular outcome of the de- cision process. (There still is a potential cost to United; by not taking individual employees’ preferences into account in making job assignments, the firm may have to pay higher wages to attract and retain.)
Summary Firms transform inputs into outputs, which are sold to customers. An important ele- ment of organizations is partitioning the totality of tasks of the organization into smaller blocks and assigning them to individuals and/or groups within the firm. Through the design process, jobs are created. Jobs have at least two important di- mensions: variety of tasks and decision authority. This chapter focuses on decision authority. The next chapter focuses on the bundling of tasks.
In centralized decision systems, most major decisions are made by individuals at the top of the organization. In decentralized systems, many decisions are made by lower-level employees. Decentralized decision making has both benefits and costs. Potential benefits include more effective use of local knowledge, conservation of se- nior management time, and training/motivation for lower-level managers. Potential costs include contracting and coordination costs and less effective use of central in- formation. The optimal degree of decentralization depends on the incremental bene- fits and costs, which vary across firms and over time. There has been a recent trend toward greater decentralization, motivated in part by increased global competition and changes in technology.
Decision rights are not assigned just to a hierarchical level but to particular po- sitions within the hierarchical level. Similar to the centralization versus decentral- ization problem, relevant factors in making this horizontal choice include the dis- tribution of knowledge and the costs of coordination and control.
Sometimes, firms assign decision rights to teams of employees rather than to specific individuals. Firms assign decision rights to teams for at least three basic purposes: Managing activities, recommending actions, and making products. The use of team decision making sometimes can increase productivity; but this is not always the case. Team decision making is most likely to be productive when the relevant information is dispersed and the costs of collective decision making and controlling free-rider problems are low.
Decision management refers to the initiation and implementation of decisions, whereas decision control refers to the ratification and monitoring of decisions. When individuals do not bear the major wealth effects of their decisions, it generally is im- portant to separate decision management from decision control. This principle helps explain the presence of hierarchies in most organizations. It also can help make the concept of empowerment more precise.
Sometimes, firms adopt rules that limit the discretion of decision makers; for exam- ple, airlines assign routes to flight attendants based on seniority. One benefit of limiting discretion is that it reduces incentives of individuals to engage in excessive influencing activities. Some influencing activity is valuable in that it produces information that im- proves decision making. Firms are, therefore, most likely to limit discretion when the firm’s profits are not very sensitive to the decisions, yet the decisions are of considerable concern to employees.
Chapter 12 Decision Rights: The Level of Empowerment 403
404 Part 3 Designing Organizational Architecture
P. Bolton and M Dewatripont (2013), “Authority in Organizations,” The Handbook of Organiza- tional Economics, R. Gibbons and J. Roberts eds, 342–372.
E. Fama and M. Jensen (1983), “Separation of Ownership and Control,” Journal of Law & Economics 26, 301–326.
M. Jensen and W. Meckling (1995), “Specific and General Knowledge, and Organizational
Structure,” Journal of Applied Corporate Finance 8:2, 4–18.
G. Miller (1993), Managerial Dilemmas: The Political Economy of Hierarchy (Cambridge University Press: Cambridge).
12–1. Joan Zimmerman owns a local CPA firm. The company employs 10 CPAs and some additional staff employees. Joan sets her own pay and makes most of the major decisions
facing the firm. Joan often initiates new ideas and implements them. The company has
no board of directors, and no one is responsible for monitoring Joan’s actions. Does this
organizational arrangement contradict the basic principle concerning the value of separating
decision management and control? Explain.
12–2. Traditionally, lending decisions at financial institutions were made by people relatively high up in the organization. For instance, a senior loan officer might have to approve even a
small loan. Recently, some financial institutions have decentralized this decision, some-
times to people without college degrees. Discuss why it might have historically made sense
to centralize the lending decision. Discuss potential factors that might have motivated the
decentralization of these rights in certain organizations.
Solutions to Self-Evaluation Problems 12–1. Separation of Decision Management and Decision Control
It is important to separate decision management and control when the decision maker is
not the owner of the firm. Otherwise agency problems are likely to significantly reduce
the value of the organization. In this example, Joan Zimmerman owns the company.
Therefore, there is no agency problem between her and other owners. In this situation,
combining decision management and control is ok.
12–2. Decentralization
Presumably the decision right was held high up in the organization because the relevant
specific knowledge was located there. For example, the lending decision requires expert knowl-
edge, credit histories, and so on, which might not have been available to lower-level workers.
• Technology—technology allows information on credit rules, credit reports, and the like, to
be accessed by people lower in the organization. Also, expert systems allow the computer
to do technical analysis previously performed by well-trained employees.
• Deregulation—increases competition and potentially increases the importance of speed
and quality of customer service.
12–1. Discuss the costs and benefits of decentralized decision making relative to centralized deci- sion making.
12–2. Mark Wilson, chief of personnel, has been instructed to increase the hiring of women at the Morton Cement Company. Mark will be evaluated by the company president Josh Cohen on
his success or failure in meeting this goal. Mark does not evaluate the performance of any of
the division chiefs, and each chief must approve all new division employees. Do you expect
Mark to succeed in this endeavor? Why or why not? Explain your reasoning.
12–3. Define the terms decision management and decision control. Under what circumstances might it be optimal to make one individual responsible for both decision management and
decision control? What do you expect the ownership of common stock to look like in such
a firm? Explain.
Review Questions
Self-Evaluation Problems
Suggested Readings
12–4. Jan van der Schmidt was the founder of a successful chain of restaurants located through- out Europe. He died unexpectedly at the age of 55. Jan was sole owner of the company’s
common stock and was known for being quite authoritarian. He personally made most of
the company’s personnel decisions. He also made most of the decisions on menu selection,
food suppliers, and advertising programs. Employees throughout the firm are paid fixed
salaries and were closely monitored by van der Schmidt. Jan’s son, Karl, spent much of his
youth driving BMWs around Holland and Germany at high speeds. He spent little time
working with his father in the restaurant business. Nonetheless, Karl is smart and just re-
ceived his MBA degree from a leading business school. Karl has decided to follow his fa-
ther as the chief operating officer of the restaurant chain. What advice about organizational
architecture for the company would you offer Karl now that he has taken over?
12–5. Discuss the positive and negative effects of a university rule that would not allow profes- sors to change a grade once recorded.
12–6. Many companies have been experimenting with organizing their manufacturing around teams of employees. The employees are given decision rights on such things as how to
organize the work and employee schedules. Often the employees are paid based on team
output. Sometimes, this organizational arrangement has worked well. In other cases, it has
not. Discuss the conditions under which you think that this type of team organization is
most likely to succeed.
12–7. A leading business school currently uses study teams in the MBA program. Each team has five members. Some of the work in the first year is assigned to study teams and graded on
a group basis. Discuss the trade-offs involved with enlarging student study groups in the
MBA program from five to six people.
12–8. It is frequently argued that for empowerment to work, managers must “let go of control” and learn to live with decisions that are made by their subordinates. Evaluate this argument.
12–9. It is sometimes argued that empowerment can be successful only if managers learn to live with decisions made by lower-level employees. Managers are to set clear boundaries
within which employees can make decisions (e.g., allowing a salesperson to set prices be-
tween $15,000 and $20,000). Managers should never overturn a decision if it is within the
boundaries. Rather, good decision making should be encouraged through proper incentives
and training. Do you agree that for empowerment to work, managers should always set
clear boundaries and live with decisions within these boundaries? Explain.
12–10. Several Fortune 100 companies have nominated members of the clergy to be members of their boards of directors. Discuss the advantages and disadvantages of such a proposal.
12–11. An organizational consultant evaluates your division. She indicates that she does not like the divisional manager’s top-down management style. She recommends setting up a board
that consists of the divisional manager and his top 10 department managers. The consul-
tant suggests that all major policy decisions be made by the board by a majority-voting
rule. She argues that this process will make for better use of information within the
organization. She also argues that our political system is a democracy, which works well,
and that the same concept could be applied beneficially within the corporation. Evaluate
the recommendation.
12–12. The Colorado Symphony Orchestra (CSO) was formed after the Denver Symphony was no longer financially viable. CSO’s corporate charter requires that it cannot have an operating
deficit in any year. Revenues, donations, grants, and other income must equal or exceed
operating expenses. CSO balances its budget each year by adjusting the musicians’ salaries.
For example, in 1999 the musicians were not paid for the last two weeks of the year.
CSO’s board of directors and executive management committees are composed of one-
third each of musicians, full-time CSO staff, and community supporters of the CSO.
In most organizations, it is unusual for labor to have representation on the board of
directors and management committees. Explain why you would expect musicians to have
seats on the CSO board and management committees.
Chapter 12 Decision Rights: The Level of Empowerment 405
406 Part 3 Designing Organizational Architecture
12–13. Recently a number of companies have adopted what is known as open-book management. Under this concept lower-level employees are given training to help them understand the
company’s financial statements and how their individual actions affect financial perfor-
mance. They are given access to information previously known only to more senior man-
agement. They are also given detailed revenue and cost data as it relates to their jobs. For
instance, one company gave delivery drivers information about the maintenance costs of
the company’s vans, whereas a building company gave employees detailed cost informa-
tion on such items as a spoiled batch of glue. Why do you think this management trend is
occurring now, rather than say 20 years ago? Does this policy fit with other changes that
are occurring in organizations? Explain. Do you think all companies should “open their
books” to lower-level employees? Explain.
12–14. Encarta is a multimedia encyclopedia on CD-ROM, which Microsoft produced from 1993 to 2009. It had nine different editions. Examples include editions in British English, Amer-
ican, German, and Italian. The North American version alone had 40 million words and
45,000 articles. Microsoft delegated major editorial decisions to teams of local experts,
mostly academics and specialists “who know their stuff.” For example, a team of experts
primarily from Italy was given editorial decisions for the Italian edition. Encyclopedia Bri-
tannica uses a different policy. Its central staff has decision rights to ensure a standard pre-
sentation is presented in all editions. Discuss the pluses and minuses of Microsoft’s policy
relative to Encylopedia Britannica’s.
12–15. Blue Cross Blue Shield of Rochester is Rochester’s largest health insurance provider. In exchange for the insurance premiums they pay, families insured by BCBS receive all their
health care needs from a group of approximately 500 doctors approved by BCBS. (Fami-
lies must choose their doctors from among these 500 doctors.)
When a patient insured by BCBS visits a doctor for a consultation, the patient pays a
small copayment (usually $20). The doctor is reimbursed for the difference between the
cost of the consultation and the copayment by RCIPA Corp. RCIPA Corp. is a firm
owned by the 500 doctors who are BCBS-approved. At the beginning of each fiscal year,
BCBS and RCIPA agree on a total dollar amount that BCBS will pay to RCIPA for med-
ical services provided to patients covered by BCBS. BCBS further agrees that this dollar
amount will not be adjusted for higher- or lower-than-expected medical care required by
BCBS patients. RCIPA in turn pays member doctors, based on a fee schedule, for the
medical services they provide to BCBS-insured patients. If, at the end of the year, there
is any money left over, it is distributed to RCIPA members. If there is not enough money
to pay for all the services provided by the member doctors, then the shortfall is allocated
among the member doctors who must contribute cash to make up the shortfall.
Why do you think RCIPA serves as an intermediary between BCBS and the doctors
who care for BCBS’s clients? Why would BCBS risk paying “too much” for the medical
care of their customers? Why would RCIPA and its members risk being “underpaid” for
their services? Is one of the two parties forcing the other to agree to such an arrangement?
If so, who is forcing whom? Why?
12-16. Studies of Information Technology (IT) services consistently show that IT services are or- ganized differently in large versus small firms. Larger firms often locate independent IT
centers throughout the firm (e.g., within each product division), where each center main-
tains its own decision rights. Smaller firms often have just one IT unit or center that serves
all divisions. Provide a potential explanation for this observation.
In large firms, some business functions are consolidated centrally instead of being
controlled by the various divisions of the company. One example is environmental
compliance and control, which is a function responsible for complying with environmental
regulations and managing the risk of impacts on the environment. Provide a potential ex-
planation for this observation.
Some large firms are highly diversified and others are more focused. Holding firm size
and the number of product divisions constant, which type of firm (diversified or focused)
is more likely to have decentralized IT units? Explain.
12-17. By the year 2000, General Motors had decentralized primary decision rights for designing cars to vehicle line managers. In earlier years, General Motors had a centralized corporate
design group. This group maintained key decision rights for the designs of all GM models.
Discuss the trade-offs between these two organizational arrangements.
Managers commonly delegate decisions to groups of employees through the use of teams, committees, and task forces. The presumption is that team members have im- portant specific knowledge to make the decisions and that they are more likely to buy in to decisions when they participate in the decision-making process. Managers should realize that team members’ interests are unlikely to be aligned either with each other or with the interests of the owners. Also, group decision processes some- times can be manipulated by team members. It is critical to understand these poten- tial problems with teams; they are the topic of this appendix.
The Example of Majority Voting Suppose that Hassan Ragab, a senior executive, appoints a team of three managers to recommend a new marketing strategy. Patrick Stefan, Maria Lopez, and Sean Mac- Donald are from the finance, marketing, and sales departments, respectively. Hassan wants the three managers to recommend the strategy that would maximize the value of the firm. However, given their current compensation schemes and positions within the company, they are more closely aligned with the interests of their particular de- partments than with the firm as a whole. For instance, Sean is evaluated by the vice president of sales. Sean knows that his vice president will be unhappy with any rec- ommendation that reduces the size or influence of the sales department. Sean thus has incentives to represent the vice president’s views on the task force.
The managers are considering three options, labeled Plans A, B, and C. The top panel of Table 12.1 shows the preferences of the three managers. Each prefers a dif- ferent plan. The managers decide to select a plan through a majority vote. When all three plans are considered together, each receives one vote and there is no winner. The managers, therefore, decide to conduct pairwise votes. The middle panel of Table 12.1 displays the outcomes of all possible pairwise votes. The bottom panel shows the ultimate outcomes from the three possible sequences of pairwise votes. Any one of the three plans can win, depending on the order in the election! This ex- ample suggests that agenda control can be critically important. If Maria has the right to select the order of voting (for instance, if she is appointed the team leader), she can manipulate the voting outcome in her favor.16
Majority voting is commonly used in group decision making—especially when the group is large. For instance, task forces of 20 or more people commonly vote on
Appendix: Collective Decision Making15
Chapter 12 Decision Rights: The Level of Empowerment 407
15This appendix draws on K. Arrow (1963), Social Choice and Individual Values ( John Wiley & Sons: New York). See also Chapter 19.
16Our example assumes that the managers vote their preferences in each round of the voting. Managers might
choose to vote strategically: They might vote in a manner that is inconsistent with their preferences in the first round to achieve a preferred outcome in the final round of voting. (For example, some Republicans voted for
Hillary Clinton in the 2008 Democrat primary in Texas, even though they planned to vote for John McCain in
the general election. They reasoned that the longer Barack Obama had to campaign against Clinton, the more
likely McCain would be successful in the general election.) Although strategic voting is a strong possibility
in this setting, the basic point of our analysis remains: Managers can influence the outcome if they have
agenda control. See Appendix Problem 2. Note also that majority voting does not always result in this type of
order-dependence outcome. It depends on the preferences of the individual team members.
408 Part 3 Designing Organizational Architecture
issues. Sometimes, other voting rules are used. For instance, some groups require unanimity for passage (each person has a veto). Others require a supermajority (e.g., two-thirds of the votes). Small groups often do not vote on issues formally. Rather, they make decisions by consensus. Nonetheless, the basic points of our analysis continue to hold—the outcome need not be efficient, can be subject to manipula- tion, and can depend on the order in which proposals are considered. Indeed, Nobel prize–winner Kenneth Arrow has demonstrated that any collective decision-making mechanism, other than granting the decision right to an individual, is subject to the types of problems illustrated in this example (depending on the preferences of the individuals in the group).
The analysis in this appendix has several important implications for managers who delegate decisions to groups of employees:
• Managers should not presume that members of a team always will have the in- terests of the company as their primary objective—there are incentive prob-
Preferences
Most Favored Second Favored Least Favored
Pat A C B Maria B A C Sean C B A
Pairwise Votes
A versus B A versus C B versus C
Pat A A C Maria B A B Sean B C C Winner* B A C
Sequence of Pairwise Votes
Round 1 Round 2 Ultimate Winner
A versus B B† versus C C A versus C A† versus B B B versus C C† versus A A
*Majority-voting rules. †Winner of the first round.
Table 12.1 Majority Voting and Agenda Control
This table presents an example of how the outcome of a series of pairwise votes can depend on the order in which the votes are taken. The top section shows the preferences of the three managers who are voting on the proposals, A, B, and C. The middle section shows the outcomes of all possible pairwise votes. The example assumes that the managers vote their preferences in each election. A majority-voting rule is used. The bottom section displays the ultimate outcome of a sequence of pairwise votes (the winner of the first vote is run against the remaining proposal). Any outcome is possible, depending on the order of consideration. In contrast to this example, the order of consideration does not always matter in majority voting—it depends on the individual preferences of the voters.
lems. These problems must be considered in forming a team. Sometimes, people with important information should be excluded from a team if the con- tracting costs of including them on the team are substantial.
• Managers often can reduce the incentive problems on teams through incen- tive compensation plans. In our example, the existing compensation scheme motivated the managers to focus on their own departments rather than on the firm as a whole. Compensating the managers based on the firmwide val- uation effects of the team’s recommendation would alter these incentives. If all three managers were concerned about the overall value of the firm, there would be no problem.17
• Agenda control can be a powerful device in group decision making. Not only can the outcome be affected by the order of the voting (as in Table 12.1) but also it can be affected by the timing of the election. For instance, the vote might be set when it is known that a particular manager will be absent. Senior executives, therefore, have an interest in who is appointed to positions such as team leaders and committee chairs. In this example, the senior executive should favor a team leader who cares about firm-value maximization—agenda control would be used to benefit the overall firm.
Analyzing Managerial Decisions: Collective Decision Making 1. What factors should a manager consider when deciding on the composition of a
team charged with making an important decision?
2. Suppose the managers in the example in this appendix do not necessarily vote ac- cording to their preferences in each round of the voting. Rather, they might vote for a less preferred option in the first round to obtain a preferred outcome in the final round. Suppose that Patrick has agenda control. How should he manipulate the agenda to achieve his preferred outcome?
Chapter 12 Decision Rights: The Level of Empowerment 409
17It is difficult to develop incentive schemes that completely resolve incentive problems within teams. As we
discuss in the text, it is difficult to design schemes that hold individuals fully responsible for their own actions.
Thus, there often are incentives to free-ride in teams. We discuss this issue in greater detail in subsequent
chapters.
chapter
13 C H A P T E R O U T L I N E
Bundling Tasks into Jobs
Specialized versus Broad Task Assignment
Productive Bundling of Tasks
Bundling of Jobs into Subunits
Grouping Jobs by Function
Grouping Jobs by Product or Geography
Trade-offs between Functional and Product or Geographic Subunits
Environment, Strategy, and Architecture
Matrix Organizations
Mixed Designs
Network Organizations
Organizing within Subunits
Recent Trends in Assignments of Decision Rights
Summary
Appendix: Battle of the Functional Managers
T ime Inc.—one of the largest branded media companies in the world and publisher of over 30 magazines including Time, Sports Illus- trated, People, Fortune, Golf, and Money—announced plans to lay off 500 employees (about 6 percent of its staff) to simplify the op-
erating structure of its magazines.1 This reorganization eliminates the previ- ous structure of Time’s magazine group, which was organized into three units: Style and entertainment, sports and news, and lifestyle topics. Now all the magazines will be consolidated into a single group, and the various mag- azine editors will report to business managers at Time, instead of group ed- itors. The proposal is designed to streamline the decision-making process and foster new products across its different magazine brands. Time justified the changes by arguing that the company must innovate to avoid further job cuts. Its CEO stated, “we need to dissolve the complex matrixed organiza- tion created several years ago, remove layers that slow us down, and free up investment dollars to deploy in growth areas.”
New digital technologies rendered obsolete the old print-magazine model used by Time as well as most traditional publishers. In response, we observe firms changing their business strategies, which necessitates changing their organizational architectures. At Time, decision-right assignments were changed including how jobs are bundled into tasks. Instead of having sepa- rate managers for style and entertainment, sports and news, and lifestyle magazines, the individual magazine editors now report to just one of two central managers of Time Inc.
Decision Rights: Bundling Tasks into Jobs and Subunits
1Details of this example are from W. Launder (2014), “Time Inc. to Cut Jobs in Restructuring,” The Wall Street Journal (February 4), www.wsj.com/news/articles/SB1000142405270230485110 4579362720955779980; and www.timeinc.com.
L E A R N I N G O B J E C T I V E S
1. Describe the trade-offs between broad and specialized task assignments. 2. Describe the factors that cause firms to group jobs by function, products, and
geography.
3. Explain how changes in the firm’s business environment or strategy can affect subunit structure.
4. Identify matrix, mixed, and network organizations. 5. Discuss some recent trends in how firms assign decision rights.
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 411
The results at Time Inc. suggest that the bundling of tasks into jobs and subunits can affect a firm’s performance. This chapter examines these important managerial decisions. We begin by analyzing the problem of how to bundle tasks into jobs. We then consider the problem of combining jobs into subunits of the firm. We conclude the chapter by discussing recent trends in the assignment of decision authority and the bundling of tasks. The appendix to this chapter uses a simple game-theoretic ex- ample to illustrate some of the basic principles from this chapter.
Bundling Tasks into Jobs In the previous chapter, we discussed how jobs have at least two important dimen- sions—breadth of decision authority and variety of tasks. We then analyzed the topic of decision authority in greater detail. We now focus on the second dimension, the bundling of tasks. The problem of how to bundle tasks obviously is quite complex; unfortunately, limited formal analysis of the topic exists. Nonetheless, the problem is economic in nature: Managers face a set of economic trade-offs when they bundle tasks. And fortunately, as in the case of decision authority, important insights into the nature of these trade-offs can be gained through analyzing simple examples.
Specialized versus Broad Task Assignment
FinWare Inc. is a distributor of financial software. Its customers include both individ- ual consumers and businesses. Within FinWare, there are two primary activities or functions, selling software and after-sales service (helping customers install the soft- ware on their systems and managing its interface with other programs). Thus, as dis- played in Figure 13.1, FinWare must perform four basic tasks—sales and service for each of its two customer groups. Of course, these four basic tasks could be subdivided into a much larger number of smaller tasks. To keep the analysis tractable, we ignore this finer partitioning and assume that the firm has but four tasks. Our analysis readily ex- tends to more general cases.
FinWare operates at multiple locations throughout the country. At its planned new Greensboro office, each of the four tasks is expected to take four hours per day to com- plete. Thus, the firm must hire two full-time employees to staff this office. In structur- ing the two jobs, the most obvious alternatives are to have each employee specialize in
Function
Customer type
Individuals
Businesses
Task 1 Task 2
Sales Service
Task 3 Task 4
FinWare, Inc.Figure 13.1 Tasks at FinWare
FinWare is a distributor of financial software. Its customers include individual consumers and businesses. Within FinWare, there are two primary activities or functions, selling software and after- sales service (helping customers install the software on their systems and interfacing it with other programs, for instance). As displayed in the figure, FinWare must perform four basic tasks in sales and service for each of the two customer groups.
412 Part 3 Designing Organizational Architecture
one function (either selling or service), that is, performed for both customer groups or have one employee provide both sales and service to individual consumers and the other employee perform both functions for business customers. We refer to the first al- ternative as specialized task assignment and the second as broad task assignment. We now examine the relative benefits and costs of these two groupings.
Benefits of Specialized Task Assignment There are at least two important benefits that can arise from using specialized rather than broad task assignment:
• Exploiting Comparative Advantage. Specialized task assignment allows the firm to match people with jobs based on skills and training and correspondingly has employees concentrate on their particular specialties. For example, FinWare can hire salespeople to sell and technicians to provide service. The principle of comparative advantage suggests that this specialization often will produce higher output than having individuals perform a broad set of tasks—there are potential economies of scale in concentrating on a more focused set of tasks.
• Lower Cross-Training Expenses. With specialized task assignment, each employee is trained to complete one basic function. With broad task assign- ment, employees are trained to complete more than one function, which can be expensive. For instance, suppose at FinWare the service function requires a skilled technician with an advanced college degree, whereas the sales func- tion requires an individual with only a high school diploma. Specialized task assignment allows FinWare to hire one person with an advanced degree and one person without an advanced degree. With broad task assignment, the level of education required is usually the highest level across the assigned tasks. Thus, broad task assignment requires FinWare to hire two people with ad- vanced degrees and train them to perform both functions. Because it costs more for FinWare to hire a person with an advanced degree than a person with only a high school diploma, broad task assignment is more expensive than specialized task assignment.
Costs of Specialized Task Assignment Specialized task assignment has advantages relative to broad task assignment, but it also has drawbacks. Some of the costs of specialized task assignment include
• Forgone Complementarities across Tasks. Sometimes, performing one task can lower the cost of having the same person perform another task. Two tasks are said to be “complements” when doing more of one activity either increases the benefits or reduces the costs of doing another activity. For ex- ample, important information about a customer’s service requirements might be gained through the sales effort. This information is less likely to be uti- lized if sales and service are conducted by separate people: It can be costly to transfer the information to the other individual. As another example, con- sider the case of two employees on an automobile assembly line. The first at- taches the door to the car frame; the second attaches the latching mechanism and makes sure the door latches to the frame. If the first does not align the door properly, the second will have more difficulty getting the door to latch properly. Combining both tasks into one job increases the care with which the person attaching the door checks for proper alignment prior to attaching the latch.
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 413
• Coordination Costs. The activities of specialized employees have to be coor- dinated. For instance, FinWare would have to establish procedures for trans- ferring sales orders to service technicians. Also, it might have to appoint a manager to handle exceptions to these procedures (for instance, before com- mitting to the purchase of the software, a customer might demand authorization for specialized installation). Developing procedures and coordinating activities can be expensive.
• Functional Myopia. With specialized task assignment, employees tend to concentrate on their individual functions rather than on the overall process of providing good sales and service to customers. For example, a salesperson who is compensated primarily through commissions will have incentives to sell software to customers even if the sale imposes large service costs on the company, such as when the company’s software is not well matched with the customer’s existing computer system.
• Reduced Flexibility. Failure to cross-train employees has costs as well as benefits. For example, if only one person is trained to perform a particular function, what happens if the person is sick or on vacation? Also, having only one person trained to do a job in a firm can place the firm at a disadvantage when bargaining with the employee over salary and other benefits.2 These problems are likely to be greatest in small companies, since large companies are more likely to have several people trained to perform any given task.
Incentive Issues Our discussion of the costs and benefits of specialized versus broad task assignment has focused on informational and technological considerations. Incentive issues also can be important. From an incentive standpoint, sometimes it is better to have employees concentrate on a narrow set of tasks, while in other circumstances, a broad set of tasks is better.
Adam Smith on the Economies of Specialization With specialized task assignment, employees concentrate on performing a narrow set of tasks. Adam Smith, an
important 18th-century economist and philosopher, was among the first to recognize the potential gains from this type
of specialization. In his classic book, The Wealth of Nations, he argued how a number of specialized employees, each performing a single step in the manufacturing of pins, could produce far more output than the same number of
generalists making whole pins. Smith presents the following description of a pin factory using specialized employees:
One man draws the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper.
Smith argues that a small factory with 10 specialized employees could produce about 48,000 pins a day, while
10 employees working independently could not have produced 20 pins per day.
Source: A. Smith (1776), The Wealth of Nations (Modern Library: New York, 1937), 4.
H I S T O R I C A L A P P L I C AT I O N S
2L. Stole and J. Zwiebel (1996), “Organizational Design and Technology Choice with Nonbinding Contracts,”
American Economic Review 86, 195–222.
414 Part 3 Designing Organizational Architecture
With broad task assignments, the firm is concerned not only with how hard em- ployees work but also with how they allocate effort among the tasks.3 For in- stance, senior managers at FinWare would be concerned with the way employees balance their efforts between sales and service. Designing an evaluation and com- pensation scheme that motivates an appropriate balance of effort is complicated by the fact that the effort exerted on some tasks often is more easily measured than for other tasks. At FinWare, the sales effort might be estimated easily by sales volume, while it might be quite difficult to measure the quality of after-sales service—for many producers there are no good direct indicators of service qual- ity, and poor quality might reveal itself very slowly over time (primarily as cus- tomers fail to make repeat purchases). If FinWare pays a sales commission, em- ployees will concentrate on sales at the expense of providing good after-sales service to customers: Selling increases their incomes, whereas providing better service has a small impact (it increases income through its effect on repeat pur- chases). FinWare can reduce this incentive to misallocate effort by not paying a sales commission. But this provides employees with relatively low incentives to exert effort on either task. One potential response to this problem is to use spe- cialized task assignments. The salesperson could be provided high-powered in- centives to concentrate on sales. The service person would not be evaluated on quantifiable output measures, but on more subjective measures, such as customer- satisfaction surveys. We discuss these issues in greater detail in Chapters 15 and 16, where we address how to measure performance.
M A N A G E R I A L A P P L I C AT I O N S
Delta Airlines versus China Eastern Airlines: Broad versus Specialized Task Assignments China Eastern Airlines, China’s second largest carrier, has a call center in Shanghai with over 1,200 employees who
only handle ticketing. If a customer calls for any other issue or complaint, the call is routed to other departments. This
often results in long delays to resolve the issue, and ultimately to disgruntled passengers. The poor customer call
service and other service-related problems (long baggage transfer times, long passenger connection times, and low-
quality gates), provided by China Eastern and the other large Chinese carriers, have allowed other Asian carriers,
mostly headquartered in South Korea, Hong Kong, and Japan, to capture a disproportionately high fraction of fliers
between China and the United States. By some estimates these other Asian airlines are capturing additional revenues of
about $250 million from the 3.8 million passengers flying between the United States and China.
Unlike China Eastern’s call center, Delta Airlines’ center handles a wide range of passenger problems from lost
bags to missed connections, and ticketing problems. On average, Delta strives to resolve passenger complaints within
18 minutes. Delta call center agents sometime even write personal letters to complaining passengers.
China Eastern uses specialized task assignments where each call center agent is assigned a single type of problem,
which causes its complaining passengers to be rerouted, frequently through several agents, until arriving at the one who
can resolve the issue. Delta uses broad task assignments whereby each agent is trained to resolve a variety of problems,
resulting in faster resolution times and happier customers.
Source: S. Carey (2014), “Delta, China Eastern Try to Solve Air Traffic Riddle,” The Wall Street Journal (March 19), www.wsj.com/articles/SB10001424052702304732804579425363833070996
3B. Holmstrom and P. Milgrom (1991), “Multitask Principal-Agent Analyses: Incentive Contract, Asset
Ownership and Job Design,” Journal of Law Economics and Organization 7, 24–52.
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 415
In some cases, producing output requires the coordinated execution of several sepa- rate tasks that individually are difficult to assess. Here, it can make sense to assign all the tasks to one individual who is accountable for the final product. For instance, in the example of attaching doors and latches to automobiles, assigning both tasks to one em- ployee makes it easy to identify who is to blame if the door does not latch properly. Sim- ilarly, at FinWare the failure of a customer to make a repeat purchase might be due to ei- ther poor sales effort or poor service. Having one employee conduct both sales and service facilitates identification of the employee responsible for the unhappy customer.
Costs and Benefits of Specialized Task Assignment*
Benefits Costs
Comparative advantage/economies of scale Forgone complementarities across tasks Lower cross-training expenses Coordination costs
Functional myopia Reduced flexibility
*Incentive issues can favor either specialized or broad task assignment, depending on the nature of the production technology and information flows.
Productive Bundling of Tasks
The choice between specialized and broad task assignments depends on the techno- logical, informational, and incentive issues discussed above. One variable, that is, likely to be of particular importance in making this decision is the relative degree of complementarity among tasks within, versus across, functional areas. At FinWare, the magnitude of the benefits of specialized task assignment depends largely on how related the selling efforts are between the two customer groups. If there are only minor differences between selling to individuals and businesses, training employees to do one makes them well prepared to do the other. In contrast, if the selling tasks are quite different between individuals and businesses, little is gained by training one employee to perform the two selling tasks compared to training separate employees. As a con- sequence, any economies of scale that result from specializing in sales are likely to be small. Similarly, the costs of specialized task assignment at FinWare depend on the importance of complementarities across functional areas. When these comple- mentarities are low (for instance, little valuable information is gained about service through the selling effort), little is lost by having employees concentrate on a single function. It also is relatively easy to coordinate the individual specialists through the use of routine procedures. Ultimately, the degree of complementarity among tasks depends on how specialized knowledge is created and the costs of transferring knowledge. It also depends on the technology used in the production process.
Our FinWare example is quite simplified, and in most settings, more complicated task divisions are feasible. For instance, the selling function might have two phases—initial contact and closing the deal. The initial contact requires less special- ized product and service knowledge than closing the deal but is potentially more time-consuming. Here, it might be better for a salesperson to handle the initial contact and have a joint call by both the salesperson and service person to close the deal. As another example, at some locations, more complete specialization might be feasible. For instance, an employee at an office with a larger sales volume could con- centrate solely on selling to individuals or to businesses. While our basic FinWare
416 Part 3 Designing Organizational Architecture
example abstracts from these more complicated considerations, it nonetheless isolates some of the key considerations in deciding on how to divide tasks into jobs.
Bundling of Jobs into Subunits Our discussion of specialized versus broad task assignment highlights the economic trade-offs of bundling tasks into jobs. Managers are confronted with a similar set of trade-offs when they bundle jobs into subunits (e.g., departments, business units divisions, and subsidiaries).
Theoretical Research in Economics on Multitask Agency Problems Provides Useful Managerial Insights In this chapter we summarize the major insights about task assignments, as suggested by the ever growing body of
theoretical and empirical research on the internal organization of firms. This box summarizes several important
theoretical papers that provide useful insights on how various factors stressed in this chapter are likely to affect the
bundling of tasks.
Several influential papers in economics examine the general problem of motivating employees to work and
providing incentives to allocate their attention among several different activities (or tasks). For example, a salesperson
must allocate her effort between securing current sales from existing customers and cultivating future sales from new
customers. How this salesperson allocates her effort to these two different tasks depends on the relative benefits she
derives from the two tasks and by the technological complementarity or substitutability across tasks. The key
theoretical insights are: Encouraging effort on one task often crowds out effort on the other task and when a single
agent is given multiple tasks to perform, the incentive scheme must balance incentives across various tasks. These
incentives depend on the ability of the principal to measure the agent’s performance of the various tasks. Tasks that
have similar degrees of measurability of whether the task was performed should be assigned to the same agent. Agents
who are assigned tasks, that are easy to measures, can be given more powerful financial incentives. These economic
models predict that the firm will assign tasks to agents that are all easy or hard to measure (with high-powered
incentives provided only when precise measurement exists), or the firm will assign the various tasks to separate agents.
In the previous analysis, the two tasks do not conflict. Current sales and future sales both enhance firm’s, value.
Sometimes the two tasks do conflict, as in the case of launching a new product that cannibalizes the sales of the current
product. If the same agent is tasked with selling both the current and the new product, the agent is likely to sabotage
one product and focus on the other. To solve this problem, the job design should avoid these conflicts of interest by
using a narrow task assignment. Each task should be assigned to managers specializing in that task. For example, assign
the task of selling the current product to one manager and the task of selling the new product to a different manager.
Then, rely on competition between the specialized managers to ensure overall balance.
Finally, multitask problems also arise when the labor market tries to infer the agent’s talent from his output
performance. In these models, the agent is paid a fixed wage and his incentive to work is solely his desire to convince
the labor market that he has high talent, so he can secure future promotions. In this case, the agent’s incentive to exert
effort on one task depends on how the labor market infers the agent’s talent based on his performance on that task. As
the number of tasks the agent is assigned increases, it becomes more difficult for the market to infer his talent. By
limiting the number of tasks assigned to the agent, the agent increases his total effort and the principal’s total profit
increases. The optimum task assignment is to have agents specialized in tasks that require similar talents, so as to
enhance the labor market’s ability to infer the agent’s talent based on his overall performance.
Source: P. Bolton and M. Dewatripont (2013), “Authority in Organizations,” in R. Gibbons and J. Roberts (Eds.), The Handbook of Organizational Economics, 342–372; and M. Dewatripont, I. Jewitt, and J. Tirole (2000), “Multitask Agency Problems: Focus and Task Clustering,” European Economic Review 44, 869–877.
A C A D E M I C A P P L I C AT I O N S
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 417
Grouping people together within a subunit lowers the communication and coordi- nation costs among the people within the subunit. For instance, they often report to the same manager, who facilitates information flows and coordination. Employees also are more likely to form closer working relationships if they share the same workspace—especially if they are evaluated and compensated on subunit perfor- mance. Managers, however, must devise methods of coordinating activities across the subunits. For instance, rules and procedures must be developed for coordinating activities among interdependent subunits, managers must be appointed and granted the authority to rule on exceptions to these procedures, and liaison staff and coordi- nating committees often must be appointed to address inter-unit issues. In summary, there is a trade-off between the benefits that come from grouping people together and the costs of coordinating their activities with those performed within other subunits. In addition, it is important to consider incentive issues: Some groupings make it eas- ier to devise productive performance-evaluation and reward systems than other groupings (we elaborate on such incentive issues in Chapter 17 which discusses divisional performance evaluation).
In what follows, we begin by describing two standard methods of grouping jobs into subunits—by function and by product and/or geography. We then discuss the economic trade-offs between these two subunit designs. Following this discussion, we examine other methods that firms use to group jobs into subunits.
Grouping Jobs by Function
One common method of grouping jobs is by functional specialty (engineering, man- ufacturing, sales, finance, and so on). This organizational arrangement sometimes is referred to as the unitary form (U form) of organization because it places each pri- mary function in one major subunit (rather than in multiple subunits). Figure 13.2 displays an organizational chart for FinWare under this type of functional grouping. Individual jobs are characterized by specialized task assignment. All the sales jobs in the organization are grouped together to form a sales department, and the service jobs are grouped together to form a service department. These departments are charged with managing their particular functions across the firm’s entire product line. Senior management plays an important role in defining the architecture, coor- dinating activities across departments, making key operating decisions, and setting strategy. Rules and procedures are established for coordinating the activities across
M A N A G E R I A L A P P L I C AT I O N S
Regulation Limits Bundling of Tasks Following 9/11, the U.S. government created the Transportation Security Administration to secure the nation’s
airports by screening airline passengers before they board the planes. This federal agency employs 50,000 full-time
screeners at wages between $20,144 and $42,050. Federal rules require at least four screeners for each flight and
prohibit them from performing other tasks, such as checking in passengers or loading luggage. At small airports,
the screeners often outnumber the passengers and remain idle most of the time waiting for the two or three flights
a day. The airlines pay the cost of the TSA screeners, and these additional costs are forcing airlines to suspend
service at some small regional airports.
Source: D. Wessel (2003), “Airport Screening Allows Efficiency to Escape Attention,” The Wall Street Journal (November 6), A2.
418 Part 3 Designing Organizational Architecture
Chief Executive Officer
Sales Department Service Department
FinWare, Inc.
Figure 13.2 FinWare as a Functional Organization
This figure displays an organizational chart for FinWare when jobs are grouped by functional specialty. These jobs are characterized by specialized task assignment. All the sales jobs in the organization are grouped together to form a sales department, and the service jobs are grouped together to form a service department. These departments are charged with managing their particular functions across the firm’s entire product line. Senior management plays an important role in defining organizational architecture, coordinating activities across departments, and making key operating decisions.
M A N A G E R I A L A P P L I C AT I O N S
Hertz Separates Equipment Rental Business from Car Rentals Besides just renting cars, trucks, and vans, Hertz has a division that leases a variety of industrial and construction
equipment such as aerial manlifts, air compressors, earthmoving equipment, power generators, forklifts, material
handling machinery, pumps, and trucks and trailers as well as small tools such as chain saws, sanders, and welders.
The Hertz Equipment Rental Division has 335 branches around the world, as well as numerous international
franchisees. This division had revenues of over $1.5 billion in 2013. Worldwide car rentals in 2013 amounted to
$8.7 billion.
In 2014, Hertz announced it was spinning off this division as a free-standing, publicly traded firm. Hertz stated it
was doing this because “the separation will help each business to focus on its strategic and operational performance, …
create a stronger growth profile, and more competitive position for each company with enhanced management focus,
resources, and processes that are more directly aligned with each business’s unique strategic priorities and … allow
each business to attract and retain personnel by offering equity-linked compensation.”
Although Hertz Equipment Rental already was organized as a separate “product line” from its car rental business,
the spin off as a separate business allows the senior managers of the parent company to focus on its core business,
which owns Hertz, Dollar, Thrifty and Firefly brands with nearly 12,000 corporate and franchisees in approximately
145 countries. The spin off also focuses the Hertz Equipment Rental managers squarely on increasing the value of their
business, as they will be evaluated and rewarded on their share price.
Source: http://ir.hertz.com/2014-03-18-Hertz-Board-Approves-Separation-Of-Equipment-Rental-Business; and
http://ir.hertz.com/company-overview.
the functions. For example, detailed procedures are established to transfer sales orders to the service department. Exceptions and special cases are handled by the senior management and/or coordinating committees (which often include senior division managers and corporate staff).
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 419
Grouping Jobs by Product or Geography
Another prominent subunit design is the multidivisional form (M form) of organi- zation, which groups jobs into a collection of business units based on product or geographic area. Operating decisions such as product offerings and pricing are de- centralized to the business-unit level. Senior management of the firm is responsi- ble for major strategic decisions, including organizational architecture and the allocation of capital among the business units. Figure 13.3 shows how FinWare would look organized around product or geography. In the first case, the company
Chief Executive Officer Chief Executive Officer
FinWare, Inc.
Geographic OrganizationProduct Organization
Sales Department
Service Department
Business Products Division
Sales Department
Service Department
Consumer Products Division
Sales Department
Service Department
West Coast Division
Sales Department
Service Department
East Coast Division
Figure 13.3 FinWare as a Product and Geographic Organization
This figure shows how FinWare would look organized around product or geography. In the first case, the company is divided into a business products division and a consumer products division. Each of these divisions has its own sales and service departments that focus on the particular products of the division. (Often, jobs within the business units are grouped by functional area.) Organized geographically, the company is divided into a West Coast division and an East Coast division. In this case, the sales and service departments within each business unit serve both individual and business customers within their geographic areas.
M A N A G E R I A L A P P L I C AT I O N S
Clorox CEO Surrounds Himself with Strong Functional Specialists Don Knauss, CEO and Chairman of Clorox, gave three reasons for placing functional specialists on his senior
management team. “First, I did it to get real-time feedback on strategy and operations and on the leaders from those
functions who control most of the spending and people. Second, I wanted to force a more global view of the business.
You’re not just responsible for the United States—you’re responsible for the company in total, and for driving
capabilities, marketing, sales, R&D, and product supply globally. Third, it was to support their personal development. I
think it forces people to be on their game a little more, too.”
Source: G. Neilson and J. Wulf (2012), “How Many Direct Reports?” Harvard Business Review (April), Reprint R1204H.
420 Part 3 Designing Organizational Architecture
is divided into a business products division and a consumer products division. Each of these divisions has its own sales and service departments that focus on the particular products of the division (often, jobs within the business units are grouped by functional area). Organized geographically, the company is divided into a West Coast division and an East Coast division. In this case, sales and service departments within each business unit serve both individual and business customers within their geographic areas.
Trade-offs between Functional and Product or Geographic Subunits
Benefits of Functional Subunits At least three major benefits stem from grouping jobs by function. First, this group- ing helps promote effective coordination within the functional areas. For instance, a supervisor in service can assign employees to specific projects based on current work- load and expertise. It also is frequently easier for functional specialists to share infor- mation if they work within the same department. For example, if a service technician develops a new solution to a problem, that employee’s supervisor can help promote its use by training other technicians within the department. Second, this grouping helps promote functional expertise. Individuals focus on developing specific functional skills and are directly supervised by knowledgeable individuals who can assist and support this development. Third, there is a well-defined promotion path for employ- ees. Employees tend to work their way up within a functional department—for exam- ple, from salesperson to local sales manager to district sales manager. Having a well- defined promotion path can reduce employee uncertainty about career paths and thus can make it less expensive to attract and retain qualified employees (recall our dis- cussion of risk aversion).
Functional grouping can often take advantage of economies of scale. For exam- ple, having a single firm-wide IT group responsible for the entire firm’s e-mail system is likely to be cheaper than having each product or geographic subunit main- tain its own e-mail system.
Problems with Functional Subunits Although functional grouping has advantages, it also has disadvantages. First, there is the opportunity cost of using senior management’s time coordinating functions and making operating decisions. This time might be focused more pro- ductively on activities such as strategic planning—deciding in which businesses the company should compete and how to be successful in those businesses. Second, there can be significant, time-consuming coordination problems across departments. At FinWare, when a sale is made by the sales department, the order has to be communicated to the service department, which in turn must schedule the required customer service. This process can cause lengthy delays in serving the customer. Moreover, important information can be lost in these transfers be- tween departments. Third, employees sometimes concentrate on their functional specialties rather than on the process of satisfying customers. For instance, the sales department might focus on achieving department goals, even if that focus imposes costs on other departments in the firm. A salesperson might promise rapid installation to a customer even though the workload of the service depart- ment already is high.
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 421
Benefits of Product or Geographic Subunits An advantage of the M form of organizing large corporations—especially within dynamic environments—is that decision rights for operations are assigned to indi- viduals lower within the organization, where in many cases the relevant specific knowledge is located. For instance, the information required for the effective coordi- nation of functions might depend more on local information that would be expensive to transfer to senior executives at headquarters. As we discussed in Chapter 12, de- centralizing these decisions to the local managers of a geographic subunit helps en- sure that this local information will be used effectively. Managers of business units are compensated based on the performance of their units; this provides incentives to use this specific knowledge more productively. Decentralizing decision rights to business-unit managers also frees senior management to concentrate on other, more strategic issues. The separation of the corporate office from operations focuses se- nior executives’ attention on the overall performance of the corporation rather than on specific aspects of the functional components. A product or geographic focus pro- motes coordination among the functions that must be completed to produce and mar- ket a particular product or to serve a given geographic area.
Problems with Product or Geographic Subunits Business-unit managers tend to focus on the performance of their own units. This focus is consistent with the maximization of a firm’s value so long as product demands and costs are independent across business units. In this case, firm value is simply the sum of the values of the individual units. Frequently, there are im- portant interdependencies or synergies among units that must be taken into ac- count if a firm’s value is to be maximized. For example, there is likely to be some overlap in customers, intermediate products often are transferred between sub- units, and the units share common resources. If managers focus on their own units and do not consider these interdependencies, the overall value of the firm is re- duced. For example, the West and East Coast divisions of FinWare might compete against each other for a national customer and reduce overall profits by selling products at a lower price than if they coordinated their marketing. This problem
M A N A G E R I A L A P P L I C AT I O N S
H-P Combines Two Operating Divisions Faced with declining profits in its division that sells computer hardware to businesses that had 2003 sales of $21.1
billion but only $19 million in profits, H-P reorganized. In the $48 billion-a-year market for corporate computer
services, H-P continued to lose market share. H-P competes aggressively between IBM’s massive service offerings and
Dell’s low-cost hardware. H-P’s services division that offers consulting solutions to businesses generated 2003 profits
of $3.57 billion on $12.3 billion of revenues. To boost the performance of its computer hardware division, H-P
combined the hardware and consulting services division to form the Technology Solutions Group responsible for
computer servers, storage, services, and software. The new group is headed by Ann Livermore who previously headed
the Services Group. Since customers are looking for a strategic relationship and a partner who can bring in the
technology, H-P hardware sales are increasingly being driven by its consulting organization.
In April 2005, H-P replaced its CEO, Carly Fiorina, naming Mark Hurd CEO. H-P reported 2007 profits of
$7.2 billion on revenues of $104.2 billion.
Source: D. Bank and G. McWilliams (2003), “H-P to Reorganize Operating Units; Latest Executive Shuffle Combines Two Divisions
in Bid to Increase Growth,” The Wall Street Journal (December 9), A3; hewlett-packard.com (2008).
422 Part 3 Designing Organizational Architecture
can be mitigated by forming groups of interrelated business units and basing a component of unit managers’ compensation on overall group performance. How- ever, as we discuss in the upcoming chapters, developing a compensation scheme that appropriately motivates unit managers is not easy. Splitting functional per- sonnel among business units also forgoes potential economies that might result from combining similar specialists within one subunit.
Benefits and Costs of Functional Organization as Opposed to Product or Geographic Organization
Benefits Costs
Improved coordination among Less effective use of local product or geographic functional specialists information
Promotes functional expertise Opportunity cost of senior management time Provides a well-defined Coordination problems among subunits
promotion path Functional focus: It is difficult to design compensation Captures economies of scale plans that promote a focus on profits and customers
Where Functional Subunits Work Best Functional grouping works best in small firms with homogeneous products and mar- kets. In these firms, it is easier for senior managers to coordinate operating decisions across departments. For large firms with more diverse product offerings, senior exec- utives are less likely to possess the relevant specific knowledge for making opera- tional decisions for the company. In addition, the opportunity cost of having senior management concentrate on operating and coordination issues rather than on major strategic issues for the firm can be enormous.4 In such cases, grouping by product or geography often will be the preferred alternative.
M A N A G E R I A L A P P L I C AT I O N S
Citigroup Reorganizes to Control Conflicts In 2002 Citibank was accused of having analysts mislead investors by distributing biased research to help land
lucrative investment banking deals. Citibank was facing probes from the Securities and Exchange Commission, the
New York attorney general, and Congress. Citigroup decided to reorganize, creating a new unit to separate analysts
from investment bankers and thereby control potential conflicts of interest within their securities business. New York
Attorney General Eliot Spitzer embraced the move as a productive initial step. “Anything that underscores the
importance of insulating research from investment banking is positive,” said attorney general spokesman Darren Dopp.
“Actions like this could complement the broad industry reforms now being discussed.”
Thus, although most decisions about how to group jobs into subunits focus on how to facilitate information flows
and cooperation across employees, this case illustrates that there are special cases in which management wants to be
able to convince customers and regulators that an inappropriate coordination of activities is not occurring, and the
choice of job grouping can help in that process.
Source: T. Valdmanis (2002), “Citigroup Banks on Reform Plan,” USA Today (October 31), 3B; and G. Stein (2002), “Citigroup Seeks to End Conflicts,” Bloomberg News (October 31).
4O. Williamson (1975), Markets and Hierarchies (Free Press: New York).
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 423
Another variable, that is, likely to affect the desirability of functional subunits is the rate of technological change in the industry. Here, we consider technological change broadly to include new products, new production techniques, and organiza- tional innovations. Functional subunits are more effective in environments with a more stable technology, since frequent communication across functional depart- ments and specialists is less important and interactions can be handled through rou- tine rules and procedures. In addition, senior management is likely to possess more of the relevant specific knowledge to coordinate functional areas.
In less stable environments, direct communication across functional areas is more important and new situations are more likely to arise that will challenge established co- ordination procedures. In turn, senior managers are less likely to have all the relevant specific knowledge to address these challenges. Rather, the specific knowledge is more likely to be spread across employees throughout the firm. For example, the frequent in- troduction of new products increases the benefits of communication among salespeo- ple and design engineers about customer demands and preferences. Similarly, it is im- portant for development and manufacturing personnel to share information when production techniques and technologies are changing more frequently.
Finally, in a rapidly changing environment, there is likely to be more uncertainty about the appropriate organizational architecture. With divisions organized around products or geography, different divisions can experiment with different architec- tures. For example, when Citibank began offering swaps, it opened trading desks in New York, Toronto, London, and Tokyo. The different operations competed not only with other financial institutions for business but also with each other. By encouraging experimentation with the architecture of these businesses, Citibank exploited the ben- efits of economic Darwinism within the firm. As experience mounted, the best proce- dures were made standard across the bank. Thus, when an environment is more dy- namic, the desirability of a product or geographic organization increases.
Environment, Strategy, and Architecture
We have discussed how appropriate organizational architecture is influenced by the firm’s business environment and strategy. Our discussion of the appropriate subunit configuration highlights this influence. Both environmental factors (such as the rate of technological change) and the firm’s business strategy (whether the firm produces multiple products, chooses to operate in multiple locations, and so on) affect the de- sirability of functional versus product or geographic organization.
An important illustration of the influence of the environment and strategy on sub- unit design is the experience of large U.S. firms at the beginning of the 20th century. The first large firms in the United States were the railroad companies, which emerged around 1850.5 These firms initially organized around basic functions such as finance, pricing, traffic, and maintenance. As the incidence of large firms in- creased in other industries in the late 1800s (such as steel, tobacco, oil, and meat- packing), most followed the lead of the railroads and organized around basic func- tions. As companies like Du Pont, General Motors, and General Electric continued to expand—both geographically and in the number of product lines—in the early 1900s, they began faring poorly in product markets where they faced smaller, more focused competitors. Their organizational architectures did not fit their changing
5A. Chandler, Jr. (1977), The Visible Hand: The Managerial Revolution in American Business (Belknap Press: Cambridge).
424 Part 3 Designing Organizational Architecture
environments or strategies. In response, these companies began experimenting with different organizational forms. After significant experimentation, many large com- panies adopted the M form of organization. Economic historian Alfred Chandler concludes:6
The inherent weakness in the centralized, functionally departmentalized operating company . . . became critical only when the administrative load of the senior execu- tives increased to such an extent that they were unable to handle their entrepreneurial responsibilities efficiently. This situation arose when the operations of the enterprise became too complex and the problems of coordination, appraisal, and policy formula- tion too intricate for a small number of top officers to handle both long-run, entrepre- neurial, and short-run, operational administrative activities.
Matrix Organizations
Some firms attempt to capture the benefits of both functional and product or geographic organization by using overlapping subunit structures.7 These matrix organizations have functional departments such as finance, manufacturing, and development. But employees from these functional departments also are assigned to subunits organized around product, geography, or some special project. Matrix organizations are characterized by intersecting lines of authority—the term matrix refers to the intersecting lines resulting from such an organizational arrangement. Individuals report to both a functional manager and a product man- ager. Functional departments usually serve as the primary mechanism for person- nel functions and professional development. The functional managers typically have the primary responsibility for performance reviews (since they have better technical knowledge for evaluating an employee’s performance). Product or geographic unit managers provide input into these reviews. For example, in hospitals, nurses work with physicians and medical technicians in the delivery of health care in “product line” hospital units such as pediatrics or orthopedics. Much of the nurses’ specific directions in caring for a particular patient comes from physicians. Yet in many hospitals, nurses are hired, supervised, and evalu- ated by other nurses who ultimately report to the director of nursing. Physicians are assigned only advisory authority in this process.
Matrix organization often is used in industries such as defense, construction, and management consulting. These industries are characterized by a sequence of new prod- ucts or projects (e.g., building a new airplane or a new shopping mall). Individuals are assigned to work in teams on a particular project and when that project is com- pleted, they are reassigned to new project teams. Given the nature of the projects in these industries, it is important for individuals across functional areas to communi- cate and to work together closely. For example, a successful airplane design must meet the demands of the customer; thus, there are benefits from the use of product- oriented teams. However, the plane must be aerodynamically sound. Thus, these pro- jects also benefit from a high level of functional expertise, which is promoted by maintaining functional areas.
6A. Chandler, Jr. (1966), Strategy and Structure (Doubleday: Garden City), 382–383. 7For a more detailed discussion of matrix organizations, see W. Baber (1983), Organizing for the Future (The University of Alabama Press: Tuscaloosa).
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 425
Figure 13.4 shows how FinWare might look if it were organized as a matrix orga- nization. The firm maintains functional departments for sales and service. Employ- ees from these departments are assigned simultaneously to either the business- product or consumer-product subunits (teams). Functional managers focus on managing their particular function across both products, whereas product managers focus on managing particular products across functions.
A potential advantage of a matrix organization, as opposed to a functional organi- zation, is that employees are more likely to focus on the overall business process rather than on their own narrow functional specialty. However, in contrast to a pure product or geographic organization, functional supervision is maintained; there is a mechanism for helping ensure functional excellence and for providing clearer op- portunities for advancement and development.
While matrix organizations look good on paper, in practice they often are difficult to implement. Potential problems with the matrix form of organization arise from the in- tersecting lines of authority. Employees who are assigned to product teams do not automatically have strong incentives to cooperate or be concerned about the success of the team. Rather, individuals might be more concerned about how their functional su- pervisors view their work, since functional supervisors are responsible for their primary performance reviews. Moreover, employees often see their roles as being representa- tives of their functional areas. Employees might be concerned excessively about how the decisions of a product team impact their particular area. These problems sometimes can be reduced by appropriate design of the performance-evaluation and reward sys- tems. Individuals will be more concerned about the output of a product team if their compensation depends on team output. A related problem with matrix organizations is the potential for disputes between functional and product managers and the cost of
FinWare, Inc.
Chief Executive Officer
Sales Division Service Division
Business Products Team
Consumer Products Team
Business Sales Department
Consumer Sales Department
Business Service Department
Consumer Service Department
Figure 13.4 FinWare as a Matrix Organization
This figure shows how FinWare might look organized as a matrix organization. The firm maintains functional divisions of sales and service. Individuals from these divisions simultaneously are assigned to either the business-products or consumer-products subunits (teams). These teams are indicated by the shaded rectangles. The functional managers focus on managing the particular function across both products, while the product managers focus on managing particular products across functions.
426 Part 3 Designing Organizational Architecture
resolving such disputes. Having both a functional and product manager also can in- crease influence costs—there are two supervisors to influence, not one. For instance, nurses might lobby with both their nursing supervisors as well as physicians to give them good performance reviews or specific assignments.
Finally, matrix organizations can have additional layers of managers that retard decision making. The reorganization by Time Inc. that begins this chapter involved eliminating its complex matrix organization to remove layers of managers to speed up decision making.
Mixed Designs
Often, firms use more than one method to organize subunits. Chase Manhattan Bank uses three types of subunits for different activities within the bank. Some are orga- nized by product, some by geography, and some by customer. For example, Chase Delaware handles all the bank’s credit card business. The business for individuals and middle-market firms is organized geographically. Large business customers are served by specific teams that generally operate out of New York City. Frequently, these teams are set up by industry. As another example, large multinational corpora- tions often organize their international divisions around the matrix concept (with overlapping country and product managers), whereas their domestic subunits are organized around function, product, or geography.
Network Organizations
Firms (and groups of firms) have experimented with other methods of organizing subunits. One example is the network organization. Network organizations are di- vided into work groups based on function, geography, or some other dimension. The relationships among these work groups are determined by the demands of specific projects and work activities rather than by formal lines of authority. These relation- ships are fluid and frequently change with changes in the business environment.8 The Japanese keiretsu, which is an affiliation of quasi-independent firms with ongoing, fluid relationships, is another example of a network organization. Networks can facilitate information flows and cooperative undertakings among work groups. How- ever, their heavy reliance on implicit understandings and informal relationships also can lead to misunderstandings or opportunism.
Organizing within Subunits
We have examined the topic of partitioning the firm into major subunits. The same analysis applies to grouping jobs within subunits (e.g., departments). Grouping jobs into functional departments at a business-unit level is most likely to be effective when the unit is small and has a limited range of products. In contrast, in large business units with diverse product offerings, organizing by product or geography can be a more productive alternative. Product or geographic organization also is likely to be more effective in rapidly changing business environments, since senior management is less likely to have the relevant specific knowledge to make operat- ing and coordination decisions.
8A. Bollingtoft, D. Hakonsson, J. Nielsen, C. Snow, and J. Ulhoi (2009) New Approaches to Organization Design (Springer: New York).
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 427
Recent Trends in Assignments of Decision Rights Traditionally, many firms have created jobs that specify limited decision authority and narrow task assignments. In turn, these jobs have tended to be grouped by func- tional specialty—either at the overall firm level or at the business-unit level. Starting in the 1990s, there was a significant shift toward granting employees broader deci- sion authority and less specialized task assignments. Many companies also have shifted from functional subunits toward more product-oriented organizations. As we discuss below, these changes have been motivated by increased global competition and various technological changes.
To illustrate some of the factors that have motivated such organizational changes, we examine BankINC a hypothetical but representative financial institu- tion engaged in lending to commercial clients. Figure 13.5 lists the basic functions that BankINC must perform to process a credit application. The credit of the applicant has to be checked; the deal must be priced (an interest rate must
ANALYZING MANAGERIAL DECISIONS: Jog PCS
Jog PCS is a wireless telephone company. It sells
cell phones to three customer groups: (1) busi-
ness users, (2) high-volume individual users, and
(3) low-volume individual users. Currently, the
company is functionally organized. Primary
functions include product development, market-
ing, sales, and customer service. The organiza-
tional chart is as follows:
Friedrich von Hugel CEO
Jessica Wilde Product Development
Austin O’Malley Marketing
Maria Hernandez Sales
Kim Chen Customer Service
1. The CEO, von Hugel, is considering reorganiz-
ing the company as a multidivisional firm orga-
nized around customer type. Draw the revised
organizational chart.
2. Discuss the pros and cons of the proposed reor-
ganization, relative to the current structure.
3. Jessica Wilde, vice president of product devel-
opment, suggests that a matrix organization
might be better. Draw the organization chart
implied by her proposal.
4. Discuss the pros and cons of the matrix pro-
posal relative to the multidivisional proposal.
BankINC Functions
- Credit checking - Contract preparation - Pricing - Document preparation
Figure 13.5 Functions at BankINC
This figure lists the four basic functions that BankINC must perform in order to complete the process of transforming credit applications into formal credit offers.
428 Part 3 Designing Organizational Architecture
be chosen); formal contracts drafted; and final documents compiled and delivered to the applicant for execution.
Prior to the introduction of integrated IT systems for loan processing, BankINC used manual paper-based systems, and BankINC was organized around these four basic functions; it was divided into functional departments, including credit, pric- ing, contracts, and documents. Figure 13.6 shows an organizational chart for BankINC under this functional structure. Employees typically were assigned a spe- cialized set of tasks within their functional areas and given limited decision author- ity on how to complete them. For example, a clerk in the credit department might have the simple task of logging applications using prescribed procedures. Coordi- nation across functional departments was accomplished by senior management, often through formal rules and procedures. For example, BankINC had procedures for transferring credit applications among the various functional departments. De- partment heads served together on committees to assist in this coordination process. With this architecture, customers received relatively poor service. BankINC took about six days to process a credit application, and it was difficult to provide timely
M A N A G E R I A L A P P L I C AT I O N S
New Technology and Regulatory Changes Rejuvenates U.K. Auto Producers In the 1990s Britain’s auto industry faced extinction. It had high labor costs and unproductive factories building so-so
vehicles. Starting in 1994, foreign-owned auto makers bought declining British brands such as Jaguar, Land Rover,
Rolls Royce, and Mini. Germany’s BMW spent over $1 billion automating the U.K. plant producing the Mini. Other
foreign car companies have made substantial capital investments opening new or renovating existing plants, which are
operating near full capacity.
Motivating these investments has been new government regulations in the United Kingdom that permit more
flexible working conditions, which increase productivity. British workers are now more willing to adapt to a faster-
paced, more highly automated manufacturing methods. For example, the Mini assembly center has an automated
system that churns out 85 different types of five models; if options are included billions of permutations are possible.
The Mini factory has a three-shift work schedule that allows for 22.5 hours of production a day, from a two-shift,
21-hour-a-day schedule.
Worker flexibility at the Mini plant is achieved by using a “working time account” model. This allows workers to
accumulate extra working hours that they can then use during downtimes. Hourly pay remains the same, but production
varies with demand. “This is impossible in the rest of Europe on any relevant scale because of local legislation that
protects workers’ rights and pay,” said John Leech at KPMG.
BMW, which also manufactures Rolls Royce, uses “living” structures that “enable the BMW Group to react flexibly
to customer demands and market requirements throughout the world. This includes flexible working time models and
working time accounts as well as the capability to build additional numbers of certain models in other plants, if
necessary.”
These flexible working rules, coupled with lower payroll taxes, have made the U.K.’s labor costs much lower than
in Western Europe. In 2011, U.K. auto workers earned an average of €25, an hour compared to €46 in Germany and
€45 in France.
This example illustrates how local regulations that impede competition in one country create incentives for firms to
move production to more “friendly” countries; at the same time we see that job tasks are redesigned to allow more
flexible—and more efficient—production methods.
Source: M. Cauchi (2014), “Retooled Mini Plant Gears Up,” Wall Street Journal (March 25), www.wsj.com/articles/ SB10001424052702303287804579446612901468536; and www.bmwgroup.com/e/0_0_www_bmwgroup_com/produktion/
produktionsnetzwerk/produktionsstandorte/standorte/index.html.
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 429
information to the customer about the status of an application. However, each application was subject to a careful credit check and each stage of the process was conducted by functional experts.
When government regulation of banking limited competition within BankINC’s local market, few customers were lost due to delays in processing loan applications. Rather, BankINC could focus on careful and deliberate application procedures. How- ever, banking deregulation allowed new commercial banks to enter BankINC’s market and this increased pressure on BankINC to change its strategy to focus more on cus- tomer service and to shorten the time required to process a credit application. Other- wise, it faced a substantial decrease in business.
New information and computer technologies enabled BankINC to develop inter- nal systems to support an organizational change. For instance, some of the neces- sary information for processing a credit application previously was stored in a man- ual filing system. Given this system, it made sense to assign certain tasks to individuals who had both familiarity with and proximity to this data. Computeriz- ing this database allowed employees throughout the firm to access this information directly—a change that permitted the firm to reassign tasks more easily. Addition- ally, BankINC was able to develop computer programs to assist less skilled person- nel in pricing loans. Such expert systems made functional expertise less important, thereby diminishing the importance of another of the advantages of their old orga- nizational architecture.
Given these competitive pressures and new technologies, BankINC completely changed its assignment of decision rights. Under its new structure, pictured in - Figure 13.7, individual caseworkers have the primary decision rights and respon- sibility for completing all the steps required in the credit-granting process. Each financing request is assigned to one caseworker, who checks the applicant’s credit, prices the deal, and draws the contracts. Employees have substantial deci- sion authority in completing these tasks, and the functional subunits of the firm largely have been abandoned.9 Performance-evaluation and reward systems
Credit Department
Contracts Department
Pricing Department
Documents Department
General Manager
BankINC
Figure 13.6 BankINC with Functional Organization
Under a functional organization, the firm is divided into functional departments, including credit, contracts, pricing, and documents. Employees typically are assigned a specialized set of tasks within their functional areas.
9Some functional specialists remained in the organization to help the caseworkers with difficult or unusual
circumstances.
430 Part 3 Designing Organizational Architecture
correspondingly were changed to focus more specifically on processing times and customer service. With this new organizational architecture, is able to process a credit application in about four hours. Customer satisfaction has increased as a result.
Today, many firms employ professional managers or hire consultants (often with Six Sigma Black Belt training) to analyze and redesign their internal business func- tions, thereby lowering costs and improving competitiveness. The success stories from these restructurings have led some management consultants to advocate wide- spread change for all firms throughout the world. The analysis in Chapters 12 and 13,
Case- worker
Case- worker
Case- worker
Case- worker
General Manager
BankINC
Figure 13.7 BankINC’s Revised Organization
Under the revised structure, individual caseworkers have the primary decision rights and responsibility for completing all the steps in the credit-granting process. Each financing request is assigned to a caseworker, who checks the applicant’s credit, prices the deal, completes the contracts, and so on. There are some functional specialists in the firm (not shown on the chart) who help the caseworkers when difficult or unusual circumstances arise.
F.W. Taylor on Iron Workers Frederick Winslow Taylor, an industrial engineer at the beginning of the 20th century, is known as the father of
scientific management. His views were quite influential in affecting the assignment of decision rights in many firms. In
particular, he argued that the attributes of lower-level employees dictated that they be granted limited decision authority
and a narrow set of tasks. In his words,
Now one of the very first requirements for a man who is fit to handle pig iron as a regular occupation is that he shall be so stupid and so phlegmatic that he more nearly resembles in his mental make-up the ox than any other type. The man who is mentally alert and intelligent is for this very reason entirely unsuited to what would, for him, be the grinding monotony or work of this character. Therefore the workman who is best suited to handling pig iron is unable to understand the real science of doing this class of work. He is so stupid that the word “percentage” has no meaning to him, and he must consequently be trained by a man more intelligent than himself into the habit of working in the accordance with the laws of this science before he can be successful.
Most modern managers reject this view of lower-level employees. The workforce of today is better educated than in
Taylor’s time, and modern production technologies often require less brawn but increased knowledge. Correspondingly,
many managers have empowered lower-level employees by giving them broader decision authority and a less
specialized set of tasks.
Source: F. Taylor (1923), The Principles of Scientific Management (Harper & Row: New York), 59.
H I S T O R I C A L A P P L I C AT I O N S
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 431
however, indicates that a firm should not restructure without carefully considering whether a reassignment of decision rights is warranted given its particular business environment and strategy.
Although changes in technology and competition have changed the optimal as- signment of decision rights within many firms, these shifts have not occurred in all in- dustries. The benefits of narrow task assignment and functional specialization are still likely to be high for many firms in relatively stable industries. Consider, for example, a small coal-mining operation. Here, it is likely to continue to make sense to have some employees concentrate on mining the coal, while other employees sell it, and still other employees deliver it.
M A N A G E R I A L A P P L I C AT I O N S
Flattened Firms Replace the Decentralized M Form The decentralized M form of organization arose as firms diversified their businesses either by adding new products or
moving into new geographic regions. Technology and new global markets motivated these strategic and organizational
changes. Now, firms face vastly more complex and competitive environments. Markets demand shorter product life
cycles that push firms to make faster decisions that are more responsive to customers. Advanced information
technology improves access to data, facilitates coordination, and speeds communication within firms. These market
and technology driven shocks have forced firms to adopt more focused, less diversified business strategies. New
strategies require different organizational architectures: different ways of partitioning decision rights, different
incentive schemes, and different human capital skills. To implement new business strategies, firms have modified their
organizational architecture in ways that differ from the traditional, highly decentralized M-form organization.
Large firms are getting “flatter.” They “delayered” by removing management levels and granting senior managers
broader spans of control. Flattened firms frequently retain more decision rights at the top. For example, one layer that
was removed is the position of Chief Operating Officer. Their CEOs also centralize more functions and have more
functional managers reporting to the CEO, executives such as the Chief Financial Officer, Chief Human Resource
Officer, Chief Quality Officer, Chief Information Officers, and so forth. While division managers in these flatter firms
are now closer to the top and have more performance-based pay, in many cases their total compensation is less.
The flattened firm appears more centralized. But the simple terms of “centralization” or “decentralization” do not
fully capture what is happening. Division managers make tactical decisions such as what products to offer and what
prices to charge, whereas corporate headquarters retain decision rights over managing the corporate brand and
implementing corporate-wide cost-cutting programs.
Source: J. Wulf (2012) “The Flattened Firm: Not as Advertised,” California Management Review 55, 5–23.
ANALYZING MANAGERIAL DECISIONS: Bagby Copy Company
Bagby Copy Company is a worldwide producer of
copy machines. It manufactures 10 different
copiers, ranging from low-end desktop copiers that
sell for a few hundred dollars to high-volume docu-
ment machines that retail for over $200,000.
Each copy machine requires a wiring bundle.
Each bundle contains several hundred wires and
connectors that provide circuits connecting the
paper-flow units, scanner, and photoreceptor to
the internal computer logic. The wire harness is
plugged into various components during the assem-
bly process. It is possible to assign each major task
in this process to different employees. For example,
a given employee might focus on one of the many
432 Part 3 Designing Organizational Architecture
Summary The bundling of tasks into jobs and subunits of the firm is an important policy choice that can affect a firm’s productivity dramatically. The primary purpose of this chap- ter is to examine this bundling decision.
We distinguish between two types of jobs: those with specialized task assignment and those with broad task assignment. With specialized task assignment, the employee is assigned a narrow set of tasks concentrated within one functional specialty—for example, sales. With broad task assignment, the employee is assigned a broader variety of tasks. The benefits of specialized task assignment relative to broad assign- ment include exploiting comparative advantage and lower cross-training expenses. The costs of specialized task assignment include forgone complementarities from not performing multiple functions, coordination costs, functional myopia, and reduced flexibility. Incentive issues might favor either specialized or broad task assignment, depending on the production technology and information flows. The appropriate bundling of tasks depends on the magnitude of the costs and benefits of each alter- native. One variable, that is, likely to be of particular importance is the relative de- gree of complementarity among tasks within, versus across, functional areas. Spe- cialized task assignment is favored when the complementarity of tasks within a functional area is relatively high.
Firms can group jobs into subunits based on functional specialty, geography, product, or some combination of the three. Functional subunits group all jobs per- forming the same function within one department (e.g., a sales department). Senior management plays a major role in coordinating these departments and in making op- erating decisions. Benefits of functional organization are the promotion of coordina- tion and expertise within functional areas and provision of a well-defined promotion path for employees. Problems with functional organization include the high oppor- tunity cost of employing senior management time to coordinate departments and make operating decisions, handoffs across departments that can take significant time, coordination failures across departments, and employees concentrating on their own functional specialties rather than on the customer. Functional subunits are likely
connectors or on testing the completed wire har-
ness. Alternatively, one individual might be as-
signed the task of producing and testing a
completed harness.
In either case, there is a group of employees that
is assigned individual tasks to produce a wire har-
ness for a particular copier. In total, there are 10
subgroups of wire harness makers. One alternative
is to place all 10 groups in one wire harness depart-
ment. Another alternative is that each of these 10
subgroups can be assigned to and report to a man-
ager responsible for a particular copier.
Bagby operates in five European countries.
Currently, it has separate subunits in each country,
where a country manager handles the manufactur-
ing and marketing of all 10 copiers. The company
is considering two alternatives. One would be to
organize its foreign operations around products.
In this case, there would be 10 international prod-
uct managers with decision rights for managing the
manufacturing and sale of a particular copier
throughout Europe. The company also is consider-
ing a matrix organization, organized around prod-
uct and country.
1. What are the trade-offs that Bagby faces in
choosing between specialized and broad task
assignment?
2. What are the trade-offs between these two
methods of grouping wire harness makers into
subgroups?
3. Which trade-offs does Bagby face in choosing
among the country, product, and matrix forms
of organizing its international operations?
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 433
to work best in smaller firms with a limited number of products operating in rela- tively stable environments.
Larger, more diverse firms often find it desirable to form subunits based on product or geography. In the multidivisional (M form) firm, operating decisions are decentral- ized to the business-unit level. Senior management of the firm is responsible for major strategic decisions, including finding the optimal organizational architecture and allo- cating capital among business units. A primary benefit of the M-form corporation is that decision rights for operations are assigned to individuals lower in the organization where relevant specific knowledge often is located. Managers of business units are compensated based on the performance of their units so as to provide incentives to use this specific knowledge productively. Decentralizing decision rights to business-unit managers also frees senior executives to concentrate on other issues. Problems with the M form of organization arise because business-unit managers often have incentives to take actions that increase the performance of their business units at the expense of other units within the firm. These problems can be controlled through careful design of busi- ness units and by basing a component of business-unit managers’ compensation on group performance—where the group consists of profit centers with interrelated costs and demands. It is usually difficult, however, to control this problem completely. Mul- tidivisional firms also forgo potential economies that might result from combining similar functional specialists within one unit.
Some firms maintain an overlapping structure of functional and product or geo- graphic subunits. These matrix organizations have functional departments such as fi- nance and marketing. Members of these departments are assigned to cross-functional product teams (subunits). Team members report to both a product manager and a func- tional supervisor. Generally, performance evaluation is conducted by the functional supervisor. Matrix organizations are common in project-oriented industries such as de- fense, construction, and consulting. They also are common in hospitals. An advantage of a matrix organization, in contrast to a pure functional organization, is that individu- als are more likely to focus on the overall business process rather than just on their own narrow functional specialty. Potential advantages over a pure product organization are that the functional departments help ensure functional excellence and provide more clearly identified opportunities for advancement and development. Potential problems with the matrix organization arise from the intersecting lines of authority. An employee is likely to have loyalties divided between the goals of the project team and the goals of the functional department. This problem can be mitigated by appropriate design of the performance-evaluation and reward systems. However, as we shall see in subse- quent chapters, accomplishing this objective can be difficult.
Firms often use more than one method for organizing subunits. They also use other less standard ways of organizing subunits. One example is a network organization.
Decisions on how to group jobs must be made at many levels in the organization. Our analysis of the costs and benefits of alternative groupings of jobs focuses on the overall firm level—how to form major subunits. This same basic analysis applies to the grouping of jobs at lower levels within the firm.
Historically, many firms have created jobs that are low in decision authority and narrow in task assignment. Recently, there has been a trend toward granting employees more decision authority and broader task assignments. Many companies also have shifted away from functional subunits toward more product- oriented organizations. These trends can be explained by specific technological changes and increases in global competition, along with accompanying changes in business strategies.
434 Part 3 Designing Organizational Architecture
P. Bolton and M. Dewatripont (2013), “Authority in Organizations,” in R. Gibbons and J. Roberts
(Eds), The Handbook of Organizational Economics (Princeton University Press, Princeton NJ), 342–372.
A. Chandler, Jr. (1977), The Visible Hand: The Managerial Revolution in American Business (Belknap Press: Cambridge).
A. Chandler, Jr. (1966), Strategy and Structure (Doubleday: Garden City).
O. Williamson (1983), Markets and Hierarchies (Free Press: New York).
13–1. For many years, your firm has been protected by patents. Technological change and the introduction of new products have been slow. Soon, these conditions will change. Your
patent protection is expiring, and the rate of technological change and innovation has
increased substantially. Discuss how these changes are likely to affect your firm’s optimal
bundling of tasks into jobs and subunits.
13–2. In the early 1900s, General Motors had separate divisions that manufactured Buicks, Cadil- lacs, Chevrolets, Oaklands, and Oldsmobiles. Decision rights were highly decentralized,
and there was little direction or coordination from the central corporate office. As a result,
the divisions often failed to coordinate decisions on design standards, which prevented them
from taking advantage of economies of scale in buying or making common components
(e.g., spark plugs). Discuss potential organizational changes that GM might have adopted to
reduce this coordination problem.
Solutions to Self-Evaluation Problems 13–1. Patent Expiration and Organization
With the old environment, technology was changing very slowly and there was limited
competition in the product market. Such an environment is more likely to favor central-
ized decision making, specialized task assignment, individual decision making, and func-
tional organization. Employees are better evaluated on their performance in narrowly de-
fined tasks. With the new environment, technology is changing rapidly and
product-market competition is more intense. In this environment, centralized decision
making is less likely to work well because much of the relevant knowledge is located
lower in the organization. Thus, decision rights are more likely to be more decentralized.
Also, it is more important for employees to communicate horizontally (to address how to
handle new situations, etc.). This will motivate less specialized task assignment, the use
of teams, and a more process-based organization. The performance-evaluation and reward
system will have to be changed in response to changes in decision rights; for example,
teamwork and cooperation might be weighted more heavily.
13–2. Organization of GM
One possibility is to merge some of the units to form fewer divisions. Divisions producing
similar products could be placed together. Another possibility is to keep the divisional struc-
ture but form larger groups of divisions. Some of the compensation of managers could be
based on group performance. Another possibility is to take certain functions, such as pur-
chasing, out of the divisions and place them in functional departments at the corporate level.
13–1. Discuss the costs and benefits of specialized task assignment relative to broad task assign- ment. What variables are likely to be particularly important in determining the optimal
choice between these two alternatives?
13–2. Define the following: functional organizations, product organization, geographic organiza- tion, matrix organization, and network organization.
13–3. Discuss the circumstances under which you think functional organizations will work best.
Review Questions
Self-Evaluation Problems
Suggested Readings
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 435
13–4. Discuss the pluses and minuses of matrix organizations.
13–5. Why do you think many U.S. firms have reorganized their international divisions from a country focus to matrix organizations focusing on both country and product?
13–6. In the early 1990s, Chrysler Corporation placed nearly all decisions about the development of a new vehicle in the hands of a single, cross-functional product team. In contrast, Gen-
eral Motors used an approach that placed a stronger emphasis on functional specialties.
Small teams were established that consisted of experts from the same functional field.
Each team was charged with a particular assignment that related to its area of specializa-
tion. For example, one team might have had the primary responsibility for the design of
the body of the vehicle, whereas another team might have been charged with developing
the drive train. The teams worked simultaneously on their specific tasks. Some individuals
on these teams also served on additional cross-functional teams that were charged with co-
ordinating the development process across the functional areas. Discuss the relative advan-
tages and disadvantages of these two approaches to product development.
13–7. Johnson & Johnson ( J&J) is one of the largest medical products companies in the world. In 1994, it had 33 major lines of business, with 168 operating companies in 53 countries.
Decision rights in J&J were quite decentralized. For instance, in 1993, the baby oil man-
ager in Italy ran his own factory and got to decide such things as package size, pricing, and
advertising. Similarly, other country managers had considerable discretionary authority for
similar products sold in their countries. This type of decentralized decision making has
served J&J well: Its returns to shareholders have been very good. Significant changes,
however, are occurring in J&J’s environment. In particular, trade barriers have been signif-
icantly reduced in Europe.
a. Describe the advantages of J&J’s decentralized decision making that have helped to explain the success of the company.
b. What organizational changes do you think J&J should consider given the change in the environment? Explain. Draw a new organizational chart for J&J’s international opera-
tions (based on your suggestions).
13–8. AutoMart Repair Shop is currently organized as follows: A repair manager meets with the cus- tomer to discuss the problems with the car. A repair order is completed. The mechanics special-
ize in particular types of repairs (e.g., air conditioning, body work, etc.). Typically, a car in the
shop requires work by several specialists. The manager plans the sequence of service among
the specialists. The car is then serviced by each of the necessary specialists in turn. Discuss
how AutoMart Repair Shop might look if it reorganized around the process of fixing an auto-
mobile. Discuss the pluses and minuses of the current structure compared to the more product-
oriented structure.
13–9. Many companies are making increased use of telecommuting, which consists of employ- ees working out of their homes, linked to the central office by telephone, computer, and
fax machine. Discuss the benefits and costs of telecommuting. What types of occupations
are likely to be best suited for telecommuting? Explain why.
13–10. Evaluate the following statement: “It is usually best to organize as a matrix organization. Matrix organizations combine the best of both worlds, functional excellence and product
focus.”
13–11. Stable Inc. is in a relatively stable environment in terms of technology, competition, and regulation. Variance Inc. is in a relatively unstable environment with more frequent
changes in technology, competition, and regulation. Both produce the same number of
products. Which firm is more likely to be functionally organized? Explain why.
13–12. Professors Brickley and Smith are writing two chapters for a new book. Two primary tasks are involved. First, someone has to write each of the chapters. Second, someone has to
copyedit the chapters. The second step involves making sure that the writing is good, that
there are no typographical errors, etc. They are considering two alternative ways to orga-
nize the work. In one case, one of the professors would write both chapters, and the other
436 Part 3 Designing Organizational Architecture
professor would copyedit both chapters. In the other case, each professor would select one
chapter and be responsible for all writing and copyediting. The two professors have equal
abilities and knowledge. Discuss the trade-offs between these two methods of organizing
the work. What factors do you think will be most important in deciding how to organize?
This appendix uses a simple game-theoretic example to illustrate some of the trade- offs that firms face in grouping jobs into subunits. Currently, the Quick Motorcycle Company is functionally organized. Two of its main departments are design and marketing. Pino Pentecoste is the manager of the design department, while Lan Nguyen manages marketing.
Pino has two options for designing a new product. One design focuses on speed, and the other design focuses on safety. Lan has two options for the corresponding marketing campaign. One option concentrates on magazine advertising and reaches older consumers, whereas the other option focuses on television and reaches younger audiences more effectively. Figure 13.8 displays the payoffs that Pino and Lan face for each combination of design and marketing programs (e.g., from their respective bonus plans or personal preferences). The payoffs indicate that coordinating the design and marketing is important. If Pino chooses design option 1, and Lan under- takes marketing plan 2, both Pino and Lan receive low payoffs ($100 each). A similar outcome exists if Pino chooses design option 2 and Lan chooses marketing plan 1. In this setting, two Nash equilibria are possible. One is design option 1 and marketing plan 1; the other is design option 2 and marketing plan 2. Pino and Lan have a conflict over which equilibrium each prefers. Pino receives a higher payoff in the first case, whereas Lan receives a higher payoff in the second case. Nonetheless, both Lan and Pino prefer either equilibrium to cases where they fail to coordinate.
Appendix: Battle of the Functional Managers10
$5,000
$2,000
$100
$100
$100
$100
Lan—Marketing plan 2
Lan—Marketing plan 2
Lan—Marketing plan 1
Lan—Marketing plan 1
$1,000
$4,000Pi n
o —
D e
si g
n 2
P in
o —
D e
si g
n 2
P in
o —
D e
si g
n 1
P in
o —
D e
si g
n 1
Figure 13.8 Battle of the Functional Managers
Quick Motorcycle Company is functionally organized. Pino Pentecoste, the manager of the design department, selects from two designs for a new product. Lan Nguyen, the marketing manager, selects from two marketing plans. There are two Nash equilibria: Design option 1 and marketing plan 1; design option 2 and marketing plan 2. Both Pino and Lan prefer to coordinate their actions rather than not coordinate (and end up on the off diagonal). However, they disagree on the preferred equilibrium.
10This example is based on the “battle of the sexes” game. For example, see R. Gibbons (1992), Game Theory for Applied Economists (Princeton University Press: Princeton).
Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits 437
Suppose total firm profits are correlated with the combined payoffs for both Pino and Lan. In this case, the CEO of the firm prefers the combination of design option 1 and marketing plan 1. With complete information about the payoff structure, the CEO selects this option and then allows the design and marketing departments to focus on their specialties in implementing this program. This focus on specialization would allow each department to take advantage of its relative strengths. It also allows Pino and Lan to coordinate the new program with other design and marketing pro- jects in their respective departments. Thus, this example illustrates that functional or- ganization can work well if the CEO has the specific knowledge to coordinate the ac- tivities of the functional managers at low cost. This specific knowledge, in turn, is most likely to be held by the CEO in small firms within relatively stable environ- ments.
In a rapidly changing environment it is unlikely that the CEO will know the payoffs facing the managers for each of the options (or even know all the available options). In this case, the CEO does not have the knowledge to order the profit- maximizing alternative. Both Pino and Lan prefer coordination to noncoordination. However, they do not agree on the preferred alternative. There is no guarantee that they will choose the value-maximizing equilibrium. Indeed, they might fail to reach either equilibrium. Pino and Lan have to make concurrent decisions.11 In an attempt to achieve their preferred equilibrium, they might fail to coordinate and both will suffer. In any case, they will consume resources bargaining (battling) over which op- tions to choose. In this environment, the CEO might want to reconfigure the subunits around products (the firm produces multiple products). The decisions on the design and marketing of each product would be made within one subunit. Profit-maximizing choices could be motivated through profit-based bonus plans. In choosing this orga- nizational option, the CEO forgoes any efficiencies that come from combining a given functional activity (across all products) within one unit. If the benefits of func- tional grouping are high, rather than changing the subunit structure, the CEO might want to foster coordination through the formation of coordinating committees and changes in performance-evaluation and reward systems that promote value- maximizing choices.
11Both design and marketing require long lead times before a final product is brought to market. It obviously
takes time to design and test a product. Similarly, in marketing, an advertising agency must be chosen, a
marketing /advertising campaign must be developed, contracts with the media have to be negotiated, and so
forth. In Lan’s and Pino’s case, both must commit to a specific option at about the same time.
chapter
14 C H A P T E R O U T L I N E
Contracting Objectives
The Level of Pay
The Basic Competitive Model
Human Capital
Compensating Differentials
Costly Information about Market Wage Rates
Internal Labor Markets
Reasons for Long-Term Employment Relationships
Costs of Internal Labor Markets
Pay in Internal Labor Markets
Careers and Lifetime Pay
Influence Costs
The Salary–Fringe Benefit Mix
Employee Preferences
Employer Considerations
The Salary–Fringe Benefit Choice
Summary
S andler O’Neill, a small investment bank with 340 employees, has focused on small- and medium-sized commercial banks.1 Sandler has underwritten their bank clients’ stocks when they went public, made a market for these bank stocks, researched their stocks, traded their
bonds, and helped them merge with and acquire other banks. At the end of 2000 it had over 1,000 clients, generated $100 million in revenues, and traded some $60 billion of bonds. Sandler was a good place to work. It was prof- itable. It paid its people well; like most investment banks, employees received large bonuses based on their productivity and overall firm profits. And it was a close-knit firm where people worked and played together.
One hundred and forty-eight of its 177 employees worked on the 104th floor of the second World Trade Center tower hit by terrorist attacks on Sep- tember 11, 2001. Of the 83 Sandler employees in the WTC at the time, only 17 survived. Two of the three managing partners who ran the firm were killed. Forty percent of its employees died—all of its bond traders, 20 of the 24 peo- ple who worked on the equity desk, its entire syndication desk, and the three key people who ran its information and communications systems.
Besides losing its hardware (including its offices and the entire communi- cations network that connected Sandler to Wall Street and made it possible to
Attracting and Retaining Qualified Employees
L E A R N I N G O B J E C T I V E S
1. Describe how the firm’s reward system is used to attract and retain qualified em- ployees as well as to motivate them.
2. Explain how a competitive labor market sets the level of pay. 3. Define the term human capital and describe the difference between general and
specific human capital.
4. Define compensating differentials. 5. Describe various ways firms learn if they have the wrong level of pay. 6. Describe the role of internal labor markets. 7. Define the term efficiency wage. 8. Understand how job seniority affects wages in internal labor markets. 9. Describe the key factors in choosing the mix between cash compensation and
fringe benefits (the composition of the pay package).
1Details of this example are from K. Brooker (2002), “Starting Over,” Fortune ( January 21), 50–68; and D. Whitford (2011) “Sandler O’Neill’s journey from Ground Zero” Fortune (September 5), http://management.fortune.cnn.com/2011/09/01/sandler-oneills-journey-from-ground-zero/.
execute trades) Sandler lost much of its wetware. The attack destroyed much of the company’s knowledge—their contacts, the way they did business, their institutional memory. All written records of the phone numbers of every person Sandler’s traders had done business with over the years were destroyed. Amazingly, an assistant who had answered the phones on the trading desk for years was able to reconstruct the list of names and numbers from memory.
Sandler O’Neill’s very existence was threatened. They faced the daunting chal- lenge of acquiring new office space and rebuilding its physical assets such as the in- formation technology and communications systems. But it also had to replace its human assets, including all the associated wetware—it had to attract and retain a new set of employees. First, Sandler had to take full advantage of its surviving wetware. It promoted or transferred existing employees into critical positions. The week fol- lowing the attacks the surviving partners appointed two partners to replace the man- aging partners who died. One bond salesman became a bond trader. The head of re- search took charge of the syndication desk. A 23-year-old assistant with less than a year’s experience was the only person who understood the workings of a new Sandler proprietary financial model used to analyze banks. And this model was critical to a pending $700 million deal. The assistant assumed the job of his boss, who had been killed. Second, it hired new employees. Sandler was helped by the massive layoffs on Wall Street that occurred following September 11. Many people who had been out of Sandler’s reach before 9/11 now were looking for a job. The sur- viving managing partner called friends at other investment banks who were laying off people and asked, “If there’s someone good getting cut, let me know, but only if they’re good. I can’t waste my time on duds.” It hired a 51-year-old retired Goldman Sachs vice president to work on the equity desk and to help recruit others for the eq- uity desk. By mid-November the firm had recruited two dozen new people, includ- ing four bond traders, three investment bankers, and two researchers. Yet some surviving Sandler employees were so traumatized by the attack that even after months of counseling they could not return to work and some of those that did were unable to perform their previous duties. Some were let go with separation agree- ments and others reassigned.
Two months after the attack, Sandler O’Neill was profitable again. Falling inter- est rates caused small- and medium-size banks to sell more bonds; Sandler under- wrote many of these deals. Sandler managed to finish every deal that was in the works before September 11. It paid its deceased employees’ estates more compensa- tion for 2001 than they had earned in their best year. More than 30 percent of Sandler’s beginning 2001 capital was paid out to the victims’ families. By 2007, Sandler O’Neill was one of the largest investment banks serving the banking and insurance industries with 262 employees.
Sandler O’Neill’s survival following the catastrophic events of 9/11 represents an extraordinary example of a management problem faced by all firms—how to attract and retain qualified employees and how to motivate these employees to be more pro- ductive. All firms must offer a level of compensation that not only allows it to attract and retain employees but also is structured to provide incentives to these employees to increase the value of the firm.
This chapter concentrates on the first of these objectives—attraction and reten- tion. We postpone a detailed discussion of incentive compensation until Chapter 15. Since the two topics are interrelated, we also discuss some incentive-related issues in this chapter. In particular, we examine how the level of pay can be used not only to attract and retain employees but also to motivate them.
Chapter 14 Attracting and Retaining Qualified Employees 439
440 Part 3 Designing Organizational Architecture
We begin by providing a more detailed discussion of the objectives of compensa- tion contracting. We then present a benchmark economic model of employment and wages. Subsequently, we extend the basic model and examine the implications of in- vestments in human capital, compensating differentials, costly information about market wage rates, internal labor markets, and the choice between salary and fringe benefits.
Contracting Objectives It is in the joint interests of contracting parties to maximize the value created by their relationships. By exploiting fully the business opportunities the firm faces and max- imizing value, the size of the overall “pie” is maximized; this permits all parties to be made better off. This general principle holds for labor contracts. By designing com- pensation contracts that maximize the value of employees’ output net of costs, the firm’s value is maximized and hence both the owners of the firm and their employ- ees can be made better off.
Individuals will not participate in an employment relationship unless they ex- pect to receive at least their opportunity cost. If they do not receive their reservation utilities—the level of satisfaction they could obtain in their next best alternative—they will quit and go to work for another firm (or withdraw from the labor force). Since individuals benefit from compensation, the level of compensa- tion is a key factor in attracting and retaining qualified employees. Owners also must receive an adequate return on their investment, or they will close the business and reinvest elsewhere. In a competitive market, paying employees more than the competitive rate results in a cost disadvantage that in the long run could drive
M A N A G E R I A L A P P L I C AT I O N S
Supply and Demand for European Investment Bankers Based on Deutsche Bank estimates, employment in European investment banks fell about 20 percent between 2010
and 2014. Moreover, pay of these investment bankers fell about 5 percent between 2013 and 2014. Driving these
changes is stagnating revenues and profits caused by new regulations. U.S. regulators prohibit U.S. banks from trading
securities for their own profit, which affects the U.S. banks’ European operating units. Bank regulators in most
countries require investment banks to hold more capital, which reduces their profitability. In fact, the 13 biggest
investment banks’ revenues have fallen 10 percent a year since 2009.
These changes illustrate the basic laws of supply and demand. Like most supply curves, the supply of bankers is
upward sloping—as salaries increase the number of people wanting to be bankers increase. Like most demand curves,
the demand for bankers slopes down. At a lower salary, the banks want more bankers. An investment bank’s demand
for bankers depends on the additional revenue the bank can generate by employing one more banker (what economists
call the marginal revenue product). In other words, if the equilibrium salary plus benefits is $100,000, investment
banks must generate additional revenue of $100,000 at the margin to justify hiring one more banker. Given the new
regulations and the declining profit opportunities in Europe, the demand curve of European bankers has shifted to the
left since 2009. Assuming there is no change in the supply curve of bankers, then both the equilibrium price of bankers
and quantity of bankers decline.
Source: “The Law of Small(er) Numbers,” The Economist (January 4), 55.
Chapter 14 Attracting and Retaining Qualified Employees 441
the company out of business. Owners thus have incentives to design compensation packages that allow them to attract and retain employees with the required skills at the lowest possible cost.
The Level of Pay
The Basic Competitive Model
In this section, we present a benchmark model of employment and compensation; it is patterned after the standard competitive model that we discussed in Chapter 6. This model is a useful starting point for analyzing issues related to the level of pay. Subsequently, we extend the analysis to consider other important issues.
Suppose the labor market is characterized by the following conditions:
• The labor market is competitive. Firms have no discretion over the wages they pay to employees; rather, wages are determined by supply and demand in the marketplace.
• Market wage rates are costlessly observable.
• Individuals are identical in their training and skills.
• All jobs are identical. They do not vary in their risk, location, level of intellec- tual challenge, travel opportunities, and so on.
• There are no long-term contracts. Rather, all labor is hired in the “spot” mar- ket for a single period.
• All compensation comes from monetary compensation. The firm provides no fringe benefits such as vacation pay or health insurance.
M A N A G E R I A L A P P L I C AT I O N S
High CEO Pay Reflects High Marginal Revenue Product Goldman Sachs Group Inc. Chairman and Chief Executive Lloyd Blankfein’s total pay package estimated at
$23 million was the biggest for a major U.S. bank in 2013. While $23 million of compensation may seem high to
many, it is only about one-tenth of 1 percent of Goldman’s net income. Goldman Sachs stated Blankfein’s
compensation was, based in part on the company’s record 2013, net income of $21.9 billion and a 14.2 percent return
on common equity, and that it reflects “in part the recovery of some investment-banking businesses, the firm’s ability
to cut costs in a generally tough environment and its resolving some of the public-relations and legal headaches that
followed the financial crisis.”
Based on the analysis in this chapter, firms must pay wages to attract and retain employees and in equilibrium
compensation levels reflect the marginal revenue product of the employee. CEOs make decisions about what deals
to do, what markets to enter, what people to promote, and so forth. The impact of such decisions on firm value is
especially high for the CEO of Goldman Sachs, one of the most prominent investment banks in the world. U.S.
CEOs generally have more authority/responsibility than CEOs of other country’s firms. Again, with more
discretion/authority, the CEO’s marginal revenue product is higher and the equilibrium level of pay should be higher
as well.
Source: S. Raice and J. Stenberg (2014), “Goldman CEO’s Pay Is Back on Top,” Wall Street Journal (March 18), www.wsj.com/news/articles/SB10001424052702304017604579447631180090114.
442 Part 3 Designing Organizational Architecture
Figure 14.1 depicts the hiring decisions of individual firms within this simple market setting. Each firm continues to hire employees to the point where the marginal revenue product equals the market-determined wage rate. Before this point, hiring additional employees produces more revenue than it costs to hire the individuals. Past this point, the costs of hiring additional individuals are greater than their benefits. The hiring de- cisions of all firms in the market determine the demand curve for labor. The supply curve is determined by the decisions of individuals on whether to accept the given wage rate or stay out of the labor force. The market wage rate equates supply and demand.
The implications of this analysis are that if a firm pays too little (below the market wage rate), it will be unable to attract or retain qualified employees. On the other hand, a firm that pays too much will have long queues for job openings. However, the firm will incur higher costs and thus will report lower profits than firms that do not overpay. Given a competitive market for its products, it eventually will go out of business.
Human Capital2
In our benchmark model, all individuals are alike. Yet employees generally vary in their abilities, skills, and training. Human capital is a term that characterizes indi- viduals as having a set of skills that they can rent to employers. The value of human
W a
g e
( in
d o
lla rs
)
Number of employees
E * E
Market wage rate
Marginal revenue product
$
Figure 14.1 How Firms Choose Employment and Wages: The Basic Competitive Model
In our basic model, firms have no discretion over the wages they pay to employees; rather, the wages are determined by supply and demand in the marketplace. As shown in the figure, individual firms continue to hire employees up to the point E*, where the marginal revenue product equals the market-determined wage rate. Until this point, hiring additional employees produces more revenue for the firm than it costs to hire the employee. Past this point, the costs of hiring additional individuals are greater than the benefits.
2This section draws on G. Becker (1983), Human Capital (University of Chicago Press: Chicago).
Chapter 14 Attracting and Retaining Qualified Employees 443
capital is determined by supply and demand in the marketplace. Individuals invest in their human capital through education and training, migration, and search for new jobs. The return on this investment consists of higher wage rates that come from hav- ing more valuable human capital—hence college graduates typically earn more than high school graduates.
It is useful to distinguish between general and specific human capital. General human capital consists of training and education, that is, valued equivalently by a broad array of different firms. Investments in general human capital include obtain- ing an MBA degree, mastering general principles of engineering, or becoming profi- cient in some new business software application. Specific human capital, on the other hand, is more valuable to the current employer than to alternative employers. Invest- ments in specific capital include such things as learning the details of a particular firm’s accounting system or product information. At Sandler O’Neill, specific capital
M A N A G E R I A L A P P L I C AT I O N S
U.S. Lags in Worker Human Capital Skills A 2012 study of workforce skills of adults aged 16–65 ranked the United States 16th out of 23 industrialized countries.
The survey judged four aspects of adult functional skills: Literacy, reading components, numerical calculations, and
problem solving. These skills constitute the basic components of general human capital required for the workforce.
And the problem is likely to get worse in the United States. Among adults aged 56–65, the United States was ranked
above the average of the 23 countries surveyed; but among adults 16–24, Americans ranked below the average country.
Source: M. Goodman, R. Finnegan, L Mohadjer, T. Krenzke, and J. Hogan (2013), “Literacy, Numeracy, and Problem Solving in
Technology-Rich Environments Among U.S. Adults,” (NCES 2014-008). U.S. Department of Education, www.nces.ed.gov/pubs2014/
2014008.pdf.
M A N A G E R I A L A P P L I C AT I O N S
CEO Pay Levels A 2014 survey of CEO pay levels in the largest 50 U.S. public firms reports the median CEO pay was $9.8 million.
Some CEOs such as John Chambers at Cisco were well above the median at $19.6 million. While these CEO pay levels
might appear large, and are often trumpeted as being excessive by the media, a couple of points are worth noting. First,
CEOs in U.S. firms exercise substantial discretion in making corporate decision making and the value implications of
these decisions—the value of the marginal product—is enormous. In a competitive managerial labor market, their
compensation should be set equal to their VMP. Second, much of what gets counted as CEO pay is not cash but rather
restricted stock or option grants whose value depends on future firm performance. For example, a CEO might be
granted 100,000 stock options with an exercise price of $12 per option that expire in three years (the exercise price is
typically set equal to the stock price on the grant date). These options might have an estimated value of $4.50 each;
hence $450,000 is reported as part of the CEO’s pay. (Given some assumptions, this is an estimate of the current value
of these options.) But they are not cash today; they are risky and only will have value if the firm’s stock price rises
above $12 over the next three years. Third, the $9.8 million median salary of CEOs in the largest 50 U.S. firms pales in
comparison to the pay of top celebrities (Oprah Winfrey at $165 million, Steven Spielberg at $130 million, Howard
Stern $105 million). The median pay of the top 50 CEOs ($9.8 million) is only about 10 percent of the median pay of
the top 20 celebrities ($90 million).
Source: T. Francis and J. Lublin (2014), “CEO Pay Rising but Not for All,” Wall Street Journal (March 26), www.wsj.com/news/ articles/SB10001424052702304026304579448961007000986; and D. Pomerantz (2012), “Oprah Winfrey Tops Our List Of The
Highest-Paid Celebrities,” Forbes (August 27), www.forbes.com/sites/dorothypomerantz/2012/08/27/oprah-winfrey-tops-our-list-of- the-highest-paid-celebrities.
444 Part 3 Designing Organizational Architecture
includes the proprietary financial model used to analyze banks and the relationships with and knowledge of their clients.
If we extend our benchmark model to allow for differences in training, firms would not invest in general training. The gains from general training go to the em- ployees, not firms: If a firm is unwilling to pay the employee the market price for the new skills, the individual moves to another firm that is willing. Thus, employees pay for their own general training. Conversely, employees are unwilling to pay for spe- cific training, since it does not increase their market values. Thus, in our benchmark model, firms must pay for specific training.
Compensating Differentials3
Our benchmark model ignores differences in working conditions across jobs. In re- ality, jobs vary in many dimensions, including quality of the work environment, ge- ographic location, length of commute, exposure to danger, characteristics of cowork- ers, and the degree of monotony associated with the tasks. Facing equal salary levels across job offers, an individual will choose the job with the most desirable charac- teristics (such as low risk of injury and attractive location). To attract employees to less desirable jobs, firms must increase the level of pay.4
The extra wage that is paid to attract an individual to a less desirable job is called a compensating wage differential. For instance, an all-night restaurant probably has to pay more to attract a manager to work at night at a more dangerous location than it does to attract a manager to work during the day at a safer location.
The prediction that unpleasant jobs pay more than pleasant jobs holds other fac- tors constant. Variation in job requirements for education, skills, and training also accounts for differences in pay. For example, an office job in a pleasant work envi- ronment might pay more than the relatively unpleasant job of garbage collector be- cause the skills required for the office job are greater. However, garbage collectors will be paid more than similar unskilled labor engaged in more pleasant tasks.
Some of the most compelling evidence of compensating wage differentials is pro- vided by studies that relate wages to the risk of fatal injury on the job.5 Using data from around the world, wages were found to be positively associated with the risk of being killed on the job, holding other factors constant. The estimates of the magni- tude of the compensating differential are relatively imprecise and vary across stud- ies, but they indicate that employees receive between $20 and $300 more per year for
3In this section, we discuss the key points of the theory of compensating differentials as they relate to
managerial decision making. For an expanded discussion of compensating differentials, see R. Ehrenberg and
R. Smith (2015), Modern Labor Economics: Theory and Public Policy, 12th edition (Prentice Hall: Boston), Chapter 8.
4This prediction assumes that employees can obtain reasonably good information about important
characteristics of the job either before or shortly after employment. This assumption is likely to be quite
reasonable in many cases. For instance, applicants for a firefighter position in an arid location are likely to
know that the job is hazardous. They also can observe the quality of the fire station and equipment.
Applicants can collect additional information about the work environment from current or past employees
which is often available on the Internet. Some argue that the level of scientific knowledge required to
understand certain hazards is beyond that held by most employees or job applicants. Yet the recognition of
basic correlations sometimes is sufficient. For instance, the expression “mad as a hatter” goes back to the
nineteenth century—long before scientists understood the details of how the chemicals used to treat the pelts
in hat making adversely affected brain function. 5For a more detailed summary of this empirical work, see Ehrenberg and Smith (2015), 268–269.
Chapter 14 Attracting and Retaining Qualified Employees 445
every 1 in 10,000 increase in the risk of being killed on the job. These estimates imply that a firm with 1,000 employees could reduce wage costs between $20,000 and $300,000 per year by increasing the level of safety enough to save one life every 10 years.
Compensating wage differentials have two important effects. First, all societies have unpleasant tasks that must be performed—for instance, most require morticians and garbage collectors. Compensating differentials attract people to these jobs and reward them for their efforts. Individuals who accept unpleasant tasks tend to be the ones who bear the lowest cost for performing them. For example, if a wage premium is offered for working in a noisy factory, the people most likely to apply are those least bothered by noise. Individuals who are particularly noise-averse would choose to work in a quiet environment at a lower wage. Second, compensating differentials cause employers who offer unpleasant work environments to have higher labor costs. Employers thus can reduce their labor costs by enhancing their work environments. This possibility implies that the firms providing better work environments will be those firms that can do so at low cost (since the marginal cost of providing a pleas- ant environment is low relative to the marginal benefit of reducing the penalty).
This discussion suggests that there is a job-matching process in labor markets where firms offer and individuals accept jobs in a manner that makes the most of
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Compensating Differentials on the “Slime Line” At Taku Smokeries in Juneau, Alaska, gutting fish is cold, wet, smelly work done by humans, not machines, on the
“slime line.” Taku produces as much as 50,000 pounds of fish a day. The line consists of a dozen workers in orange
rain gear, splattered with blood and fish guts. Using knives, spoons, and hoses they clean a flood of fish amidst
constant noise and overpowering smell. But one of the workers, Bill Razpotnik, asserts he doesn’t care. The $12 per
hour salary plus time and a half for overtime allows him to feed his family of four. Razpotnik says, “What smell? It
doesn’t bother me, I’ve slimed several million fish and one fish is just another fish. Another day, another dead fish.”
Source: E. Arnold (2002), “Dirty Work: Fish Processing,” (August 22), www.npr.org/programs/morning/features/2002/aug/
dirtywork/slimeline/index.html.
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Recruiting and Retaining Iraqi Soldiers In December 2003, the U.S. army disclosed that about 300 of the 700 members of the newly formed Iraqi army had
quit. Many of those leaving were married soldiers who were trying to support their families on a mere $60 per month.
To recruit and retain an Iraqi army the U.S.-led coalition forces raised the pay of Iraqi soldiers. By June of 2005, a
common Iraqi soldier’s pay was up to $340 a month, and generals were paid $950 a month. With an Iraqi unemployment
rate of 30 percent and with doctors in the best Baghdad hospitals earning $500 a month and most Iraqis earning $200 a
month, the pay for Iraqi soldiers contained a significant compensating differential, in part to compensate Iraqi soldiers for
the risk posed by the job.
By June 2005, the Iraqi army and paramilitary police numbered 169,000. The Iraqi army pay is so good, 7,000 men
showed up at an army recruiting center one rainy day in November 2004 on the false rumors of a new enlistment call.
Source: (2003), “Coalition May Hike Iraqi Army Pay,” (December 13), www.cnn.com/2003/WORLD/meast/12/13/sprj.irq.main/; and
S. Tavernise and J. Burns (2005), “As Iraqi Army Trains, Word in the Field Is It May Take Years,” New York Times ( June 13).
446 Part 3 Designing Organizational Architecture
their strengths and preferences. Organizations have incentives to reduce the risk of injury in order to reduce wage premiums. In turn, the people who take risky jobs are likely to be the most tolerant of risk—individuals self-select based on their risk pref- erences. For example, fishing companies often find it too expensive to reduce the risk of injury beyond some level, and thus they must offer wage premiums to crews of fishing boats. Individuals applying to work on these boats are likely to be among those most willing to place their lives at risk on the job. Because of this self- selection, the compensating differential is lower than if the firm attempted to hire a randomly selected person from the population. Firms that provide a safe environ- ment at a low cost will offer low-risk jobs and lower wages; these positions will be filled by more risk-averse employees.
Costly Information about Market Wage Rates
In contrast to our benchmark model, compensation in many labor markets is not read- ily observable. Individuals vary in characteristics and generally are not perfect substi- tutes. Thus, observing the wage for one individual does not provide full information on what it would require to hire another. In addition, firms do not share complete infor- mation about their levels of compensation. The difficulty in observing the market price for labor means that it is not always easy to tell if a firm is underpaying or overpaying its employees.
Two important indicators of whether a firm is paying the market wage rate are the number of applications it receives for job openings and the quit rate among existing em- ployees. If a firm is inundated by qualified applicants when it advertises a job opening and its quit rate is low, the firm probably is paying above the market wage rate.6 In con- trast, if the applicant rate is low and turnover is high, the firm probably is paying below the market.
In choosing the rate of pay, it is important to consider the trade-offs between in- cremental compensation and turnover costs. Turnover costs include the costs of re- cruiting employees, training expenses, and reduced productivity from employing in- experienced employees. In addition, if employees expect that they will work for the firm for only a short time, they are less likely to be concerned about how their actions affect the long-run cash flows of the firm. For instance, a salesperson might push to make a sale to collect a commission, knowing that the customer will be unhappy with the product and will reduce future purchases. Sometimes, employees who leave a firm take customers and trade secrets to competing firms. Nonetheless, turnover also has beneficial effects on the firm—for example, it adds “new blood” and fresh ideas to the organization.
Outside job offers made to existing employees also are indicative of market rates. Although these offers provide important information about the market value of ex- isting employees, firms must be careful in deciding whether to match these offers. Failure to match can result in losing valued employees. But a policy of matching all outside offers encourages employees to invest in generating such offers. This activ- ity might take time away from work and also might increase the likelihood that em- ployees will receive offers that entice them to leave the firm.
6Paying above the market wage rate typically will place the firm at a competitive disadvantage. As we discuss
next, however, there are several reasons why some value-maximizing firms might want to pay above the
prevailing market wage rate.
Chapter 14 Attracting and Retaining Qualified Employees 447
Internal Labor Markets While our benchmark model provides a reasonably good description of some labor markets, such as the market for unskilled agricultural workers, it does a poor job de- scribing employment and wages in many other cases. In contrast to the model, many firms rarely reduce employee compensation and frequently invest in general train- ing—such as paying tuition for an employee to obtain an MBA. Also, employees often invest their time and effort in developing firm-specific skills.
Many firms are better characterized as having internal labor markets, wherein outside hiring focuses primarily on filling entry-level jobs and most other jobs are filled from within the firm. Firms with internal labor markets establish long-term relationships with employees. The typical employee has been with his or her current employer for 4.6 years. But among older workers ages 55 to 64 the average tenure rises to 10.6 years. Women had stayed with their current employer 4.5 years. And, about 30 percent of men had 10 years or more of tenure with their current employer.7
Established career paths and the prospect for promotions play important roles in firms with internal labor markets. These firms interact with outside labor markets only on a limited basis. Rather than simply reflecting outside market conditions, the rates of pay (discussed in more detail later in this chapter) and job assignments in in- ternal labor markets often are determined by administrative rules and implicit under- standings. Firms can have more than one internal labor market. For example, the in- ternal market for white-collar employees might have little interaction with the internal market for blue-collar employees. In addition, firms with internal labor mar- kets typically offer some jobs that are well described by our basic model—for in- stance, certain low-skilled positions.
Agreements between employers and employees concerning compensation and re- sponsibilities are contracts. Firms generally do not enter into formal written agree- ments (explicit contracts) with nonunion employees. Rather, most employees work under implicit contracts—a set of shared, informal understandings about how firms and employees will respond to contingencies.8 Implicit contracts differ from explicit contracts in that they normally are unwritten and more difficult to enforce in a court of law. Firms and employees, however, often have strong economic incentives to honor implicit contracts to protect their reputations. A primary reason for the fre- quent use of implicit contracts is that it would be quite costly to detail all possible contingencies and associated responses in formal documents.
Reasons for Long-Term Employment Relationships
In Chapter 3, we discussed how all methods of organizing economic activity involve contracting costs. Firms have incentives to consider these costs and to organize eco- nomic exchanges in an efficient manner.9 Spot-market exchange is not always the most efficient way to organize firm–employee relationships. There are at least three factors that help promote the widespread use of the long-term employment
7Bureau of Labor Statistics, “Employee Tenure Summary in 2014” U.S. Department of Labor (September 18,
2014) www.bls.gov/news.release/tenure.nr0.htm; and R. Hall (1982), “The Importance of Lifetime Jobs in
the U.S. Economy,” American Economic Review 72, 716–724. 8S. Rosen (1985), “Implicit Contracts,” Journal of Economic Literature 23, 1144–1175. 9R. Coase (1988), The Firm, the Market, and the Law (University of Chicago Press: Chicago).
448 Part 3 Designing Organizational Architecture
relationships found in internal labor markets. These factors include specific human capital, employee motivation, and information about employee attributes.
Firm-Specific Human Capital Long-term relationships provide stronger incentives for employers and employees to invest in specific training. If employers and employees expect that their relationships will be of short duration, limited incentives exist to make these investments. In con- trast, long-term relationships allow firms and employees to capture the benefits of accumulated specific human capital.
Employee Motivation The prospect of a long-term relationship with a firm provides powerful incentives for employees to work on behalf of their employers. Employees who consider shirking, stealing, or other dysfunctional activities must weigh their potential benefits of these ac- tions against the costs of losing future benefits should they be caught and dismissed. Since there is more to lose in long-term relationships than in short-term relation- ships, the incentives both to engage in productive activities and to avoid dysfunc- tional activities are higher within long-term relationships.10 Also, as we discuss below, long-term relationships increase the flexibility that a firm retains in designing compensation packages to motivate employee effort.
Learning Employee Attributes Over time, managers receive much information about the skills, work habits, interests, and intelligence of individual employees. Employers then can use this in- formation in matching employees and jobs within the firm. For example, firms with internal labor markets have fewer surprises in filling higher-level jobs than firms that rely on outside labor markets.
Costs of Internal Labor Markets
Not all firms have internal labor markets. Some firms rely heavily on outside markets to fill positions at all levels. The observation that some firms do not operate internal
M A N A G E R I A L A P P L I C AT I O N S
Internal Labor Markets in Japan Large companies in Japan used to make extensive use of internal labor markets. Many Japanese executives would spend
their entire careers with the same firm. Senior executives virtually never moved from one major firm to another. Firms
rarely went outside to hire for any position other than entry-level jobs. Turnover was extremely low. Pay was tied largely
to seniority, and the differences in pay among employees were small relative to the differences in American companies.
Recently, poor performance has placed pressures on Japanese firms to reconsider their policies of lifetime
employment guarantees. But by 2009 more than one third of Japan's labor force consisted of low-cost part-timers,
contract workers, and temporary staff.
Source: R. Wartzman, “Japan: Rethinking Lifetime Employment” (September 04, 2009) Bloomberg Businessweek, www.business-
week.com/managing/content/sep2009/ca2009094_141933.htm
10This statement assumes that an employee cannot costlessly replicate the same stream of benefits by
changing to a new employer. For example, the new job might pay lower compensation, the individual might
incur moving costs, there might be a period of unemployment, and so on.
Chapter 14 Attracting and Retaining Qualified Employees 449
labor markets suggests that the costs of these markets can be larger than their bene- fits. One potentially important problem with internal labor markets is the restricted competition for higher-level jobs within the organization. If a firm considers only in- ternal candidates for higher-level jobs, it will not always hire the most qualified per- son—who may be from outside the firm. The likelihood of finding a desirable can- didate in the outside labor market is highest when the job does not require specific training (since experience with the firm does not create an advantage in the job). Thus, firms are more likely to use internal labor markets where specific training is important. Indeed, firms in the steel, petroleum, and chemical industries, where com- plicated production technologies take significant time to learn, tend to rely on inter- nal labor markets, whereas firms in the food services and hospitality industries do not. Firm-specific skills arguably are less important in garment and shoe manufac- turing than in steel, petroleum, or chemicals.
Pay in Internal Labor Markets
Careers and Lifetime Pay
Employees who take jobs at firms with internal labor markets often expect that they will spend much of their careers at the same firm. Thus, in considering an entry-level job, prospective employees generally will focus on the entire stream of earnings over their anticipated career path. For example, an individual might accept a job at Firm A that pays less than another job offered at Firm B because the individual anticipates faster compensation growth at Firm A.
The fact that individuals tend to base employment decisions on career earnings gives firms with internal labor markets more flexibility over choosing the level and time profile of pay. In contrast to our basic model, firms do not need to pay the mar- ket wage rate (or equivalently, in equilibrium, the marginal revenue product) at each point in time. Rather, firms can vary compensation over a career path, as long as the overall value of the remaining stream is competitive at each point in time (valued as highly by employees as streams offered by competing firms in the labor market).
Economists have identified at least three ways that firms can use their flexibility in setting the level and time profile of pay to enhance employee motivation. These methods include the payment of efficiency wages, upward-sloping earnings profiles, and tying major pay increases to promotions. As we discuss below, however, influ- ence costs can limit the extent to which firms exploit this potential flexibility.
Efficiency Wages In many jobs, it is difficult to monitor employee actions. It also is difficult to devise in- centive compensation schemes that motivate desired behavior. For example, manufac- turing companies want production employees to work hard. In most cases, it is difficult to measure employee effort with much precision. In addition, the payment of piece rates or other output-based compensation can discourage employees from paying enough at- tention to quality.
One potential way of motivating employees in such cases is to pay compensation above the market rate. Paying a premium for employees obviously increases labor costs. However, it can have the desirable effect of motivating them not to shirk. Indi- viduals who are paid a wage premium are likely to reduce their shirking because they understand that if they are caught and fired, they will have difficulty finding another job that offers such a premium. This effect will be greater for employees who have
450 Part 3 Designing Organizational Architecture
Motivating Honesty in the Local Police Force Economists Gary Becker and George Stigler were asked to consider ways of reducing corruption within the Chicago
police force. The recommendation of these Nobel laureates was to pay the police more than the market wage rate. With
sufficiently high premiums, the police would have incentives not to take bribes from criminals. For this condition to
hold, the immediate gains from taking bribes must be offset by the expected loss in wage premiums given the
possibility of being caught and fired. Thus, the required premium to prevent cheating depends on the size of the bribes
and the likelihood of getting caught. Higher bribes and lower likelihood of getting caught translate into higher required
premiums.
Paying wage premiums will entice a large number of people to apply for job openings. To reduce the surplus of
applicants, Becker and Stigler suggested that the jobs be sold to officers. The price of jobs would reflect the expected
premiums. Under this plan, the payment for a job can be considered as a bond posted by an officer not to cheat. If the
officer is honest, the officer gets the bond back in the form of the premium wage. If the officer cheats and gets caught,
the bond is forfeited.
The concept of buying jobs may seem unusual. However, this originally was the practice among yeoman warders—
the beefeaters who guard the tower of London. And today many people essentially do this when they purchase the right
to manage an outlet of a franchise company.
Source: G. Becker and G. Stigler (1974), “Law Enforcement, Malfeasance, and Compensation,” Journal of Legal Studies 3, 1–18.
A C A D E M I C A P P L I C AT I O N S
longer time horizons with the firm, since they have more to lose. Economists refer to wage premiums of this type as efficiency wages. Efficiency wages also provide in- centives for employees to stay with the firm. These incentives can be particularly im- portant when the employee has specific human capital (the firm does not want to re- place the employee with a person with less training and experience).11
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Lifetime Employment Collapses at Mitsubishi During its peak, Mitsubishi employees were like lords of the universe. Hired from the top universities and treated as
the elite, they had good jobs, security, and lifetime employment. But then the bubble burst. Using huge capital gains
from real estate to make numerous bad investments in the 1980s created huge losses in the 1990s. Mitsubishi is
actually a group of associated companies called a keiretsu. The main Mitsubishi companies (autos, banks, heavy industries) had a return on equity of 4 percent in contrast to the United States where anything less than 15 percent is
considered poor. Now, recent hires quit and look for new jobs. There is no longer the same sense of security as before.
Source: J. Adams “The demise of 'lifetime employment' in Japan,” Minnpost (May 5, 2009) 05/19/10, www.minnpost.com/
global-post/2010/05/demise-lifetime-employment-japan.
11For a more detailed analysis of efficiency wages, see G. Akerlof (1984), “Gift Exchange and Efficiency
Wages: Four Views,” American Economic Review 74, 78–83; C. Shapiro and J. Stiglitz (1984), “Equilibrium Unemployment as a Worker Discipline Device,” American Economic Review 74, 433–444; and J. Yellen (1984), “Efficiency Wages Models and Unemployment,” American Economic Review 74, 200–208. If all firms in an industry pay efficiency wages, there will be unemployment. (The supply of labor will exceed
demand.) The threat of unemployment can provide incentives for employees not to shirk. Note that in our
basic model, marginal revenue product and the wage rate are independent. The efficiency-wage concept,
however, suggests that they can be related: Employees’ marginal products can be affected by their wage rates
due to incentive effects from potential dismissal for cause.
Chapter 14 Attracting and Retaining Qualified Employees 451
Job Seniority and Pay12
Compensation typically increases with seniority within the firm. Part of this increase is explained by increases in productivity that come from experience. In many firms, however, compensation increases faster than productivity as the employee ages. Firms frequently offer attractive retirement packages to encourage older employees to retire and (unless precluded by law) often have mandatory retirement. For exam- ple, the employee must retire at age 65.13
One explanation for these age-related policies is that they establish stronger incen- tives for employees to work in the best interests of the firm. To see how, consider the example depicted in Figure 14.2. This figure displays the growth patterns of the mar- ginal revenue product and compensation for a representative employee within a par- ticular firm. Both the marginal revenue product and compensation increase as the
S a
la ry
( in
d o
lla rs
)
Tenure with the firm
Compensation
Marginal revenue product
$
T
Figure 14.2 An Example of an Upward Sloping Earnings Profile
This figure displays both the marginal revenue product and compensation for a representative employee in a given firm. Within this particular firm, both marginal revenue product and compensation increase as the employee becomes more experienced. Compensation, however, increases at a faster rate. In the early years, the employee is paid below the marginal revenue product, whereas in later years the employee is paid more. The employee is underpaid in early years yet still is willing to work for the firm because of the expectation of being overpaid in subsequent years. Under this compensation plan, young employees have incentives to work hard to avoid both being fired and losing future wage premiums. Older employees, in turn, do not want to be dismissed because they receive more than they could earn at other firms.
12This section draws on E. Lazear (1979), “Why Is There Mandatory Retirement?” Journal of Political Economy 87, 1261–1284.
13Amendments made to the Age Discrimination Employment Act in 1978 and 1986 have precluded mandatory
retirement for most workers in the United States.
452 Part 3 Designing Organizational Architecture
14This section draws from the literature on tournament theory. See E. Lazear and S. Rosen (1981), “Rank
Order Tournaments as Optimal Labor Contracts,” Journal of Political Economy 89, 841–864. 15Promotions also play an important role in matching people with jobs based on skills and ability. 16Relative performance measures are based on how an employee performs compared to a peer group. Absolute
performance measures compare the employee’s performance to some predetermined standard.
employee becomes more experienced. (The analysis does not change if we allow for declines in productivity in later years.) Compensation, however, increases at a faster rate. In the early years, the employee is paid below the marginal revenue product, whereas in later years the employee is paid more. The employee is underpaid in early years but is willing to work for the firm because of the expectation of being overpaid in subsequent years. Under this compensation plan, younger employees have incen- tives to make firm-specific human capital investments and to work hard to avoid being fired and losing future wage premiums. Older employees do not want to get fired because they are being paid more than they could earn at other firms.
Firms that employ this type of compensation policy have short-run incentives to fire older employees, since older employees are paid more than they are worth. Unjustified dismissals of older employees, however, are not in the long-run interests of these firms because they reduce the incentive effects of the compensation plan: Younger employ- ees will not believe that hard work will lead to wage premiums when they get older. To help convince younger workers that they will not be laid off in their later years, such firms frequently adopt job seniority rules whereby younger employees are dismissed first in the case of a downturn in the economy. Firms cannot pay premiums to all older employees for an indefinite period and stay in business. Thus, these firms will adopt policies that help ensure that older employees will retire when they reach a specified age. For example, if legally allowed a mandatory retirement age might be established where the present value of the underpayments in the early years offsets the overpay- ments in the later years. Thus, over their entire careers, employees are still paid their marginal revenue products (as in our basic model). Such a condition helps the firm sur- vive in a competitive marketplace.
Promotions14
Firms are typically partitioned into hierarchical levels, where the jobs at a given level pay more than positions at lower levels. Employees move up this hierarchy through promotions. Since employees compete for promotions, promotions can be viewed as contests or tournaments among employees. Employees’ productivity is higher as they try to win these contests.
Promotions obviously play an important role in providing incentives within many organizations.15 One benefit of using a promotion-based incentive scheme is that it commits the firm to serious performance reviews of its employees. Promoting the wrong person to a job can impose material costs. Employers have incentives to conduct in-depth performance reviews to reduce the likelihood of making such mistakes. An- other primary benefit is that promotion contests help filter out random shocks in eval- uating performance. Typically, the employee with the best relative performance is cho- sen for promotion. Potential risk-sharing benefits come from using relative performance measures rather than absolute performance measures.16 In particular, em- ployees are less likely to be rewarded or penalized for factors beyond their control— common shocks that affect all the contestants in the promotion contest are filtered out of the decision.
Chapter 14 Attracting and Retaining Qualified Employees 453
Promotion-based systems can have several significant drawbacks.17 First, judging people on relative performance can undermine employee cooperation, and employees might even sabotage the work of others. A survey of Australian companies finds that when promotion incentives are strong, workers are less likely to cooperate.18 Second, promotions can be a rather crude tool for providing incentives. Promotions occur only at discrete intervals, and the employee is either promoted or not. Moreover, within smaller firms as well as for employees with specialized skills, promotion opportuni- ties can be quite limited. Monetary incentives, such as bonus payments, are more flex- ible. Third, there can be serious conflicts between matching people for jobs and pro- viding incentives. The so-called Peter principle argues that employees keep getting promoted until they reach jobs that they cannot handle. Fourth, employees do not al- ways value promotions. For example, research scientists and professors often do not want administrative positions. Fifth, promotion contests can subject decision makers to significant influencing activities.19
Despite these drawbacks, promotions remain a useful method for motivating em- ployees. For example, in one large firm there was little variation in pay based on per- formance for employees within the same job grade. Rather, most pay increases oc- curred when an employee was promoted to a higher job grade.20 When pay increases are large for getting promoted, employees exert more effort. Professional golfers have lower scores and NASCAR racers drive faster when the prize money for winning the event is larger.21 When more people compete for a promotion, the increase in pay for becoming CEO is larger.22
17G. Baker, K. Murphy, and M. Jensen (1988), “Compensation and Incentives: Practice and Theory,” Journal of Finance 43, 593–616.
18R. Drago and G. Garvey (1998), “Incentives for Helping on the Job,” Journal of Labor Economics 16, 1–25. 19Promotions are typically based on the subjective judgments of people rather than on objective output
measures (such as pieces produced). As we discuss in more detail in Chapter 16, subjective performance
evaluation can motivate nonproductive actions to influence the supervisor’s rating. 20M. Gibbs and W. Hendricks (2004), “Do Formal Salary Systems Really Matter?” Industrial & Labor
Relations Review 58:1, 71–93. 21R. Ehrenberg and M. Bognanno (1990), “The Incentive Effects of Tournaments Revisited: Evidence for the
European PGA Tour,” Industrial Labor Relations Review 43, 74–89; and B. Becker and M. Huselid (1992), “The Incentive Effects of Tournament Compensation Systems,” Administrative Science Quarterly 37, 336–350.
22M. Conyon and S. Peck (2001), “Corporate Tournaments and Executive Compensation: Evidence from the
UK,” Strategic Management Journal 22, 805–815.
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A Horse Race at General Electric Sometimes, firms “run horse races” among internal candidates. Under this procedure, the candidates are notified that
they are competing for a job with higher pay and prestige. The contest provides significant incentives for the
candidates to perform since the prize for winning can be very large. General Electric ran such a horse race to fill the
CEO position when Reginald Jones retired in 1981. The winner was Jack Welch. In 2000, Jeffrey Immelt won another
leadership tournament and succeeded Welsh as GE CEO in 2001.
Source: R. Vancil (1987), Passing the Baton (Harvard Business School: Boston); and General Electric, “Notice of 2013 Annual Meet- ing and Proxy Statement” www.tscviewer.com/Ge/iversion/NoticeOf2013AnnualMeetingAndProxyStatement_i1.
454 Part 3 Designing Organizational Architecture
Influence Costs and Pay in Universities The potential for influence activity is especially high in firms where employees have common knowledge about one
another’s pay. Our discussion suggests that these firms might limit the differences in pay to reduce influence costs. One
study provides empirical evidence on this issue by examining compensation levels in academic departments at about
2,000 colleges. Common knowledge about pay is more likely in small departments, in departments where the members
frequently interact on a social basis, and in public institutions (where public disclosure of pay often is required).
Consistent with the influence-cost arguments, this study found that all three factors were associated with reductions in
the dispersion of pay.
Source: J. Pfeffer and N. Langton (1988), “Wage Inequality and the Organization of Work: The Case of Academic Departments,”
Administrative Sciences Quarterly 33, 588–606.
A C A D E M I C A P P L I C AT I O N S
Lately, the prospect for promotion in many firms has fallen due to an overall re- duction in middle-management positions. This development reduces incentives for many employees, who think that the chances for promotion are low even if they do a good job. In response, many firms have tried to restore incentives by adopting more explicit pay-for-performance plans. One 1988 survey reports that 75 percent of em- ployers in the United States have an incentive plan (such as profit- or gain-sharing plan) for rank-and-file employees.23 The use of stock options to reward executives and employees increased steadily in North America in the late 1990s. According to a survey of Fortune 200 companies, shares allocated for stock incentive plans more than doubled in the 1990s, amounting to 13 percent of all outstanding shares at the end of the decade. Two other surveys estimate that the value of stock options exer- cised by employees of large U.S. companies reached $100 billion in the year 2000, and that 19 percent of all employees were eligible for options in 1999, compared to 12 percent in 1998.24
Influence Costs
Teammates frequently compare compensation levels. Differences in pay among coworkers regularly prompt employees to seek explanations for compensation deci- sions. Employees also use information about the pay of other employees to lobby for pay increases. It frequently is conjectured that firms limit the differentials in pay to reduce this type of influence activity. Such a policy, however, comes at a cost; un- derperforming employees are likely to be paid too much, whereas more productive employees are likely to be undercompensated and leave the firm. Influence costs also help explain why many firms try to keep their compensation decisions confidential. In many cases, however, it is difficult to prevent teammates from sharing information on compensation.
Firms often expend substantial resources on evaluating and comparing jobs within the organization. One popular method is the Hay System.25 Under this
23N. Perry (1988), “Here Come Richer, Riskier Pay Plans,” Fortune (December 19), 50–58. 24E. Kupiec (2003), “Are Stock Options Good Business Options?” Management (May), www.managementmag
.com. 25For a more detailed discussion, see G. Milkovich, J. Newman, and B. Gerhart (2014), Compensation 11th
edition, (McGraw-Hill: New York).
Chapter 14 Attracting and Retaining Qualified Employees 455
system, each job within the organization is evaluated on factors such as required know-how, problem-solving skills, the number of people supervised, and account- ability. Based on this evaluation, each job is assigned a total number of points and placed in a position within the firm’s hierarchy. Jobs at a given level in the hierar- chy have similar ranges in compensation. For example, jobs included in the same level might pay from $20,000 to $25,000, depending on experience and qualifica- tions. Although salaries reflect external market rates to some extent, a major em- phasis is placed on internal consistency among jobs (equal pay for equal work). In- ternal consistency appears to reduce employee complaints about compensation policies and helps protect the firm against liability in discrimination suits. However, if pay is related to the number of employees supervised, such a plan can lead to em- pire building by managers.
The Salary–Fringe Benefit Mix26
In our benchmark model, individuals receive their compensation in the form of cash payments. Most employees, however, receive a substantial amount of their compen- sation in the form of fringe benefits—compensation that is either in kind or deferred.
Examples of in-kind payments are health insurance and membership in a com- pany recreation center, where the employee receives an insurance policy or a service rather than cash. Payments to pension plans and Social Security are examples of de- ferred compensation. For the typical American employee, about 75 percent of the total compensation package is pay for time worked, while about 25 percent is fringe benefits. Based on the cost to the employer, the most important fringe benefits are pensions and insurance, paid leave time (vacations and sick or other leave), and man- dated contributions to Social Security and Workers’ Compensation. Many employ- ees also receive benefits such as company-paid education, dental care, discounted meals, and subsidized recreation programs. A survey of college grads found the fol- lowing ranking as the most important job benefit: Medical insurance, pension bene- fits, annual salary raises, and dental and life insurance.27
Employee Preferences
Salary and fringe benefits typically are not perfect substitutes from an employee’s viewpoint. One reason is taxes: Certain fringe benefits (such as health insurance) are not subject to income taxes when received by the employees. For example, an em- ployee who wants to purchase an insurance policy that costs $5,000 would prefer that the firm provide the policy rather than $5,000 in cash. Since insurance premiums are not counted as taxable income, an employee in a 33.33 percent tax bracket would have to receive $7,500 in salary to purchase the policy. The employee also might want the firm to purchase fringe benefits because the benefits can be purchased by the firm at lower prices. For example, a firm might be able to provide group insurance at a lower cost per employee than if employees individually purchased the insurance. The potential cost advantage of employee group health and life insurance has two main
26This section draws on Ehrenberg and Smith (2015), Chapter 11. 27A. Karr (1998), “Special News Report about Life on the Job—and Trends Taking Shape There,” The Wall
Street Journal (May 5), A1.
456 Part 3 Designing Organizational Architecture
S a
la ry
( in
d o
lla rs
)
U2
U1
Fringe benefits (in dollars)
Employee preferences
$
$Figure 14.3 Employee Preferences for Salary and Fringe Benefits
This figure displays an employee’s preferences for salary and fringe benefits using indifference curves. The convexity of the curves implies that this employee is willing to substitute a relatively large amount of salary for additional fringe benefits when the employee receives few fringe benefits (possibly due to tax considerations). However, this willingness to substitute declines as the employee receives more fringe benefits (the employee wants cash for other purposes).
28D. Mayers and C. Smith (1981), “Contractual Provisions, Organizational Structure, and Conflict Control in
Insurance Markets,” Journal of Business 54, 407–434.
components: It reduces the adverse selection problems and lowers administrative and selling expenses. On the other hand, employees often prefer $5,000 in cash to $5,000 in fringe benefits, since the cash gives them more flexibility in selecting their purchases.28
In our initial discussion, we do not break fringe benefits into finer categories. Rather, we consider the choice between salary and overall fringe benefits. Later, we discuss the mix of fringe benefits. Figure 14.3 displays an employee’s preferences for salary and fringe benefits using indifference curves. The convexity of the curves implies that this employee is willing to substitute a relatively large amount of salary for additional expenditures on fringe benefits when the employee is paid primarily cash (possibly due to tax considerations). However, this willingness to substitute
ANALYZING MANAGERIAL DECISIONS: Structuring Cruise Line Compensation
You work in the human resource office of a
major cruise line that offers cruises in various
locations around the world (the Caribbean, the
Mediterranean, Asia, etc.). The CEO of your
company has recently proposed that all employees
in the corporate office (i.e., those employees who
do not actually work on a ship) be offered free
passage on your firm’s cruises as a fringe benefit.
The CEO has asked for your thoughts on this
proposal.
1. If this proposal is adopted, what will happen,
if anything, to employee salaries? Why?
2. What are the advantages and disadvantages of
this proposal? What factors should be
considered when evaluating the proposal?
Chapter 14 Attracting and Retaining Qualified Employees 457
declines as the employee receives more fringe benefits (the employee prefers cash for other purposes).
The employee, of course, would like to be on as high an indifference curve as pos- sible. A firm, however, will be able to hire the individual so long as the compensa- tion package meets the individual’s reservation level of utility. If the compensation package provides this level of utility (or more), this person is at least as well off working at the firm as working for alternative employers or not working at all. For example, the reservation utility of the individual in Figure 14.3 might be depicted by the indifference curve labeled U2. (Note that the reservation utility of the individual would increase if the compensation packages offered by other employers were in- creased so that other alternatives become more attractive.)
Employer Considerations
Initially, suppose that the firm’s managers do not care whether they pay an employee cash or use the same amount of cash to provide fringe benefits. For instance, both expenditures might be deductible for corporate tax purposes, and so it costs the firm the same amount in either case. Figure 14.4 displays isocost curves for a representa- tive firm under this assumption. Each curve is a straight line with a slope of �1; firm value is unaffected by the split between salary and fringe benefits. Along any isocost curve, expenditures to attract and retain employees are the same. The firm’s value would be highest with the lowest isocost curve possible (since lower isocost curves imply lower employee expenses and higher profits).
The Salary–Fringe Benefit Choice
Suppose that all individuals the firm might hire have similar preferences for wages and fringe benefits. Figure 14.5 depicts an indifference curve for the reservation utility of a typical employee. The firm can hire this individual, using any
M A N A G E R I A L A P P L I C AT I O N S
Employee Preferences—Body Art One out of seven Americans now sport tattoos, up from one out of a hundred in the 1970s. And it is not just blue-collar
employees, Federal judges, lawyers, and business executives brandish various forms of body art—tattoos and body
piercings. Corporate America has had to adapt in order to attract and retain a qualified workforce. While most employees
choose tattoos that are not visible to coworkers or customers, several companies have adopted policies that generally
allow visible discrete, non-offensive tattoos and body piercings that do not pose a safety risk. Tattoo policies vary across
firms. Some managers believe that tattoos can distract coworkers and clients. Bank of America has no written rules
prohibiting inked corporate employees. Some managers even see body art as a healthy way for employees to express
their individuality, and that a no-tattoo policy might result in losing excellent candidates. Many medical facilities require
a certain level of concealment during work hours to show professionalism as a way to gaining patients’ trust. For
example, the Cleveland Clinic’s policy is: “Tattoos must be covered during working hours to ensure a consistent
professional appearance while working.”
One recent study reports that 31 percent of surveyed employers ranked “having a visible tattoo” as the top personal
attribute that would cause them from promoting an employee. So, while firms are increasingly focused on diversity and
inclusion, tattoo flaunting is probably best reserved for post-work hours.
Source: R. Hennessey (2013) “Tattoos No Longer A Kiss Of Death In The Workplace,” Forbes (February 27), www.forbes.com/sites/ rachelhennessey/2013/02/27/having-a-tattoo-and-a-job/.
458 Part 3 Designing Organizational Architecture
S a
la ry
( in
d o
lla rs
)
Fringe benefits (in dollars)
$
$
−1
Isocost curves
−1
Figure 14.4 Employee Preferences for Paying Salary or Fringe Benefits
This figure displays isocost curves for a representative firm, under the assumption that the firm’s value is unaffected by whether it pays the employee cash or uses the same amount of cash to provide fringe benefits. Each curve is a straight line with a slope of �1; firm value is unaffected by the split between paying a dollar for salary or a dollar for fringe benefits. Along any isocost curve, the labor expenses for the firm are the same. The firm’s value is highest on the lowest isocost curve possible (since lower isocost curves mean lower labor expenses and higher profits).
S a
la ry
Fringe benefits (in dollars)
$
S*
U
F *
Figure 14.5 The Optimal Mix between Salary and Fringe Benefits
The figure pictures an indifference curve U for the reservation utility of a representative individual whom the firm is trying to hire. The firm can hire the individual using any compensation package along this curve. The figure also shows selected isocost curves for the firm. To maximize the firm’s value, choose the compensation package that meets the reservation utility of the individual at the lowest cost. This optimal choice is S*, F*, where the indifference curve is tangent to the isocost curve. Management could choose other combinations along the indifference curve. However, these combinations are more expensive. Although the firm could offer combinations that are less expensive than S*, F*, these combinations would not meet the individual’s reservation utility.
Chapter 14 Attracting and Retaining Qualified Employees 459
compensation package along this curve. The figure also shows selected isocost curves for the firm. Management’s objective is to choose the compensation package that meets the reservation utility of the employee at the lowest cost. The optimal choice is S*, F*, where the indifference curve is tangent to the isocost curve. Man- agement could choose other combinations along the indifference curve. However, these combinations are more expensive. Although management could offer combi- nations that are less expensive than S*, F*, these combinations would not meet the individual’s reservation utility.
This analysis suggests that it is in management’s interest to heed employee prefer- ences about fringe benefits. If employees prefer that the company buy a dental policy rather than pay them the same amount in cash, the firm should offer the dental policy. Offering the dental policy makes the employees better off and the value of the firm no lower. Indeed, if the change would result in paying employees more than their reserva- tion utilities, the firm can lower cash compensation further and share in these gains. (The firm might do this by giving lower raises in the subsequent years.) Designing more efficient contracts allows the firm to attract and retain employees at a lower cost.
We have assumed that the firm’s value is unaffected by the split between paying a given amount of cash to employees and spending the same amount on fringe bene- fits. This assumption is likely to be valid in many cases, but there are at least two complicating factors. First, taxes at the firm level can be important. For example, the firm generally has to pay Social Security taxes on wages but not fringe benefits. This tax changes the slope of the firm’s isocost curves. For example, assuming a Social Security tax rate of 6 percent, managers would be indifferent between paying $1.00 for salary or $1.06 for fringe benefits. The slope of the isocost curve is �0.943. As depicted in Figure 14.6, it is better to offer higher fringe benefits and lower salary than without the tax. Note that personal taxes are incorporated in the shape of em- ployees’ indifference curves, whereas the firm’s taxes are incorporated in the slope of the firm’s isocost curves. Thus, our analysis suggests that in designing compensa- tion packages, management should consider the total tax bill for the employee and the firm.29 Reducing the joint tax liabilities imposed on both the firm and its employees means that there is more money to split between the firm and its
M A N A G E R I A L A P P L I C AT I O N S
Fringe Benefits and Overtime In 2003 as companies emerged from the recession, many companies were reluctant to add new employees to meet their
increased demand. Instead, companies began offering employees the opportunity to work overtime, for a higher wage
per hour. A number of employees took advantage of this opportunity. Average weekly overtime rose from 4.3 hours in
October to 4.4 hours in November. One worker with 10–15 hours of overtime a week commented, “I had some
fantastic checks. It was nice, but you don’t have a life.” But other workers resisted and some even quit. Facing
increased demand, why don’t firms hire more employees who work a normal workweek at the regular wage rate? There
are two major considerations: First, it is expensive to lay off workers and hence employers are reluctant to begin hiring
until they are confident the observed increase in demand is not temporary. Second, fringe benefits generally do not
increase with hours worked. For example, health insurance rates are determined by the number of employees, not the
number of hours worked. Thus, the full cost of overtime can be less than the full cost of hiring additional workers.
Source: K. Maher (2003), “Overtime Increases as Employers Remain Cautious about Hiring,” The Wall Street Journal (December 9), D6.
29M. Scholes, M. Wolfson, M. Erickson, M.Hanlon, E. Maydew, and T. Shevlin (2015), Taxes & Business Strategy, 5th edition, (Prentice Hall: Boston).
S a
la ry
( in
d o
lla rs
)
Fringe benefits (in dollars)
$
$
S *
F *
Sʹ U
F ʹ
No payroll taxes
Payroll taxes
Figure 14.6 Optimal Choice of Salary and Fringe Benefits with Payroll Taxes
This figure illustrates how payroll taxes can affect the optimal choice of salary and fringe benefits. In the first case, the firm does not pay payroll taxes (such as Social Security) on wages or fringe benefits. The optimal choice is S*, F*. In the second case, the firm pays payroll taxes on wages, but not fringe benefits. This tax flattens the isocost curves for the firm, and the optimal choice is S�, F�. In the second case, the firm pays lower salaries and higher fringe benefits.
460 Part 3 Designing Organizational Architecture
employees. It is generally inappropriate to focus only on the taxes of one party (e.g., the firm’s taxes).
The second complication is that fringe benefits can affect employee behavior in ways that affect the firm’s profits. For example, sick leave can motivate absenteeism. Similarly, liberal insurance coverage can reduce employee incentives to worry about prices for medical care. These types of incentive effects can affect the appropriate com- pensation package. For example, some firms have reduced insurance coverage to em- ployees for the express purpose of providing employees with stronger incentives to ne- gotiate with doctors over price. Presumably, employees do not like to bargain with doctors and must be offered higher wages both to offset this increased cost as well as
ANALYZING MANAGERIAL DECISIONS: Paying for Fringe Benefits at Lincoln Electric
The willingness of firms to listen to the preferences
of employees suggests that employees pay for their
own fringe benefits. For instance, most companies
would be willing to pay higher salaries if employ-
ees did not want health insurance. Employees,
therefore, face an opportunity cost of lost salary
when they receive fringe benefits. Lincoln Electric,
a manufacturing company in Cleveland, makes this
trade-off quite clear to employees. Employees at
Lincoln receive about half their compensation in
the form of annual bonus payments. Fringe benefit
costs are taken out of this bonus payment and are
shown on the employees’ pay stubs. On several oc-
casions, Lincoln employees have voted against
dental plans because the majority of employees
prefer cash.
Critically evaluate the following statement:
At Lincoln Electric, workers must pay for their own fringe benefits (e.g., health insurance). The payment for these benefits is taken out of the an- nual bonus checks. At other firms, the firm pays for fringe benefits. Therefore, the workers at Lincoln are worse off than at other firms.
Chapter 14 Attracting and Retaining Qualified Employees 461
S a
la ry
( in
d o
lla rs
)
Fringe benefits (in dollars)
$
$
$S
$M
FS FM
Reservation utility: Married person
Reservation utility: Single person
Figure 14.7 Using the Mix between Salary and Fringe Benefits to Attract Particular Types of Employees
The figure displays an isocost curve for the firm and indifference curves representing the reservation utilities of a person who is single and a person who has a family. In this example, people with families have a higher preference for fringe benefits (e.g., health insurance) than single people who prefer cash. If management wants to attract individuals with families, it will offer high fringe benefits and low wages ($M, FM). In this case, only people with families will apply for the job. Single individuals will not apply because the package does not meet their reservation utilities. If, instead, management wants to hire single people, it will offer high salary and low fringe benefits ($S, FS).
30Our objective in this section is to describe how firms use the salary and fringe benefit mix to attract particular
types of individuals. We are not arguing that such a policy is ethical, just, or legal in all cases.
to offset the reduced insurance coverage in the fringe benefit package. However, the cost to the firm will be reduced if the increase in wages is less than the reduction in in- surance costs. These considerations can shift the slope of the isocost curves in either di- rection and thus can either increase or decrease the optimal amount of fringe benefits.
Using Fringe Benefits to Attract Particular Types of Employees Employers often care about the personal characteristics of the individuals they hire. For example, firms facing higher costs of turnover might favor hiring people with families since they might be less likely to quit. Alternatively, firms with intense work environments, such as investment banks in New York City, might favor hiring single people because they are more likely to be willing to work longer hours. Firms are con- strained in using salary offers to attract a particular type of labor force. For example, firms are likely to violate discrimination laws if they offer people with families more money than they offer single people. Firms, however, sometimes can use the mix be- tween fringe benefits and salary to attract particular types of employees.30 Figure 14.7
462 Part 3 Designing Organizational Architecture
M A N A G E R I A L A P P L I C AT I O N S
Trend toward Temporary and Part-Time Workers Part-time workers make up a growing portion of the workforce at United Parcel Service (UPS). If UPS has a peak load
in the morning and another in the afternoon, hiring part-time employees offers UPS more flexibility than taking on
more full-time employees. Many part-time employees like working a part-time schedule.
In contrast to part-time jobs, temporary jobs are full-time (40 hours per week) jobs, but not necessarily permanent.
Many companies hire temps through employment agencies to fill in when permanent employees are on extended leave
or if the job is temporary. These positions usually provide fewer fringe benefits. Microsoft and Time Warner have been
in court over whether temps who have been in the position for several years are entitled to the same benefits as
permanent employees. Who is the real employer—the employment agency or the company employing the
“permatemps”? If it is the company, it owes the temp pension benefits. An IRS complaint against Microsoft claims that
many of Microsoft’s 6,000 temps are really common-law employees and entitled to company pension benefits.
Following Microsoft’s $97 million settlement in 2000, other firms such as Hewlett-Packard and Federal Express have
been sued in “permatemp” litigation.
Source: R. Rosen, “America’s Workers: Stressed Out, Overwhelmed, Totally Exhausted” The Atlantic (March 25, 2014) www.theatlantic.com/business/archive/2014/03/americas-workers-stressed-out-overwhelmed-totally-exhausted/284615/; A. Bernstein
(1998), “When Is a Temp Not a Temp?” BusinessWeek (December 72), 67–72; and E. Frauenhein (2005), “ Battles Wax and Wane in the ‘Permatemp’ Wars,” Workforce Management (October 24).
depicts an example. The figure displays an isocost curve for the firm and indifference curves representing the reservation utilities of people who are single and people who have families. In this example, people with families have a higher preference for fringe benefits (e.g., health insurance) than single people. If management wants to at- tract individuals with families, it will offer higher fringe benefits and lower wages ($M, FM). In this case, people with families are more likely to apply for the job. Single individuals are less likely to apply because the package does not meet their reserva- tion utilities. If, instead, management wants to hire single people, it will offer higher salary and lower fringe benefits ($S, FS).
The Mix of Fringe Benefits Our basic analysis of the choice between fringe benefits and salary also applies to the choice of the mix of fringe benefits. For example, it will make sense to provide employees with disability insurance rather than dental insurance whenever the em- ployees prefer the disability insurance—assuming the same cost to the company. In this spirit, some companies have adopted menu or cafeteria-style benefit plans, where individual employees allocate a fixed fringe benefit allowance among a vari- ety of choices. The potential benefit of these plans is that not all employees value specific benefits equally. By allowing them to choose, they will be more willing to work for the firm at a lower overall cost. Note that a cafeteria plan is more likely to be valued by two-career families since, for example, one spouse can acquire dental insurance while the other obtains health insurance.
Cafeteria plans entail costs that can limit their desirability. First, they are more ex- pensive to administer. For example, employees must be informed of all their options and an administrative system has to be established to record choices, make the ap- propriate payments to suppliers, allow for changes in choices, and complete the ap- propriate tax forms.
Second, cafeteria plans can generate adverse-selection problems that increase the cost of the benefits. Adverse selection is likely to be a particular problem with health,
Chapter 14 Attracting and Retaining Qualified Employees 463
ANALYZING MANAGERIAL DECISIONS: Structuring Compensation Plans
Parkleigh Pharmacy is a small department store in
Rochester, NY, specializing in upscale, expensive
personal accessories (e.g., sunglasses, beauty aids,
leather goods) and home decorations (e.g., crystal,
china, table lamps). Kaufmann’s is a large depart-
ment store chain, based in Pennsylvania, with sev-
eral stores in the Rochester area. Kaufmann’s car-
ries a broader range of products and caters more to
middle-income consumers.
Salespeople at Parkleigh are paid a straight
hourly wage (i.e., no sales commissions). In
addition, they are entitled to a 30 percent discount
on anything they buy at the store. By contrast,
salespeople at Kaufmann’s are paid an hourly wage
(lower than the hourly wage paid at Parkleigh) plus
a commission of 5 percent on sales they make.
They receive no discount on products they buy at
Kaufmann’s.
1. Why do you think the compensation plans
differ at the two firms? In particular, why do
you think Kaufmann’s pays commissions to
salespeople, while Parkleigh does not? Why
does Parkleigh offer employees discounts on
purchases, while Kaufmann’s does not?
2. Assume, for the moment, that neither store
pays sales commissions. Parkleigh offers an
hourly wage plus the employee discount.
Kaufmann’s offers only an hourly wage. Do
you expect Kaufmann’s hourly wage to be
higher or lower than Parkleigh’s? Why?
life, and disability insurance. Individuals know more about their likelihood of getting sick than an insurance company. This asymmetric information is less a problem if the insurance company provides the benefits to all employees as a group. When free to choose, the people who are most likely to buy insurance are those who find it a good deal at the quoted price. Thus, at any given price, the insurance company is likely to attract a clientele that causes it to lose money. To reduce the likelihood of losing money, the insurance company can do things like demand physical examinations and investigate past medical records before agreeing to insure an applicant. However, these actions increase the costs of supplying the coverage. To reduce the adverse-se- lection problem, companies often allow employees to opt out of health insurance only if they can document that their spouse has coverage at another firm. This policy limits the amount of discretion that employees have on whether to buy health insur- ance and helps ensure that the insurance company will have a reasonable cross sec- tion of health risks in the pool.
Summary The previous two chapters discussed how firms assign decision rights. A second im- portant component of organizational architecture is the reward system: Productive firms design compensation plans that attract and retain qualified employees and motivate them to exert effort and make decisions that exploit the business opportuni- ties faced by the firm. This chapter examines how firms attract and retain qualified employees and how the level of pay can be used to motivate employees. The next chapter focuses on incentive compensation.
In our benchmark model of wages and employment—patterned after the stan- dard competitive model—firms have no discretion over the wages paid to employ- ees; rather, wages are determined by supply and demand in the marketplace. If a firm pays too little, it will have difficulty attracting employees to job openings and
464 Part 3 Designing Organizational Architecture
will experience high turnover. A firm that pays too much will have numerous job applicants and low turnover. In addition, the firm will have high costs and will compete poorly in the product market.
Human capital is a term that characterizes individuals as having a set of skills that can be “rented” to employers. We distinguish between general and specific human capital: General human capital consists of training and education, that is, equally useful to many different firms; specific human capital is more valuable to the current employer than to alternative employers. In our benchmark model, employees would be expected to pay for their own general training, and employers would pay for spe- cific training.
Our benchmark model does not consider differences in working conditions across jobs. Yet actual jobs vary in many dimensions, such as geographic location and the level of danger. Holding other factors constant, unpleasant jobs must pay a compensating differential to attract employees. Compensating differentials attract employees to unpleasant tasks; they also provide employers with direct financial in- centives to enhance the work environment whenever it is cost-effective.
In some settings, it can be difficult to tell whether a firm is paying the market wage rate to employees. Important indicators are the application and quit rates and the nature of outside job offers made to existing employees.
Our benchmark model provides a good description of some labor markets, such as the market for unskilled agricultural workers. It is less useful in describing employ- ment and wages in many other cases. Many firms are better characterized as establish- ing internal labor markets, where outside hiring is done primarily for entry-level jobs; most other jobs are filled from within the firm. Internal labor markets are characterized by long-term relationships between the employee and the firm. Long-term relation- ships can be beneficial because they provide both employers and employees incentives to invest in specific training, offer incentives for employees to work to exploit the busi- ness opportunities facing the firm, and allow firms to take greater advantage of infor- mation about employee attributes. One cost of using internal labor markets is that it sometimes is undesirable to limit the search to the firm’s current employees, especially when filling higher-level positions.
Employees accepting jobs with firms that employ internal labor markets evaluate career earnings. Thus, firms with internal labor markets have more flexibility in set- ting the level and career profile of pay. Firms can vary compensation over the career path, so long as the overall remaining stream of earnings is competitive at each point in time relative to the streams offered by other firms within the same labor market. Economists have identified at least three ways in which firms can use their flexibil- ity in setting the level and sequencing of pay to enhance employee motivation. These methods include the payment of efficiency wages, upward-sloping earnings profiles, and the tying of major pay increases to promotions. However, influence costs can af- fect the desirability of exploiting this potential flexibility. Firms might reduce the dis- persion of pay among coworkers to limit influence costs.
The typical American employee receives about 25 percent of total compensation in the form of fringe benefits such as vacation time, insurance coverage, and contri- butions to retirement plans. Salary and fringe benefits are not perfect substitutes for most employees. Tax benefits and the fact that the company often can purchase fringe benefits more cheaply favor fringe benefits. The desire for flexibility in mak- ing purchases can favor cash payments. Employers have incentives to heed the pref- erences of employees when it comes to the choice between salary and fringe bene- fits. By responding to their preferences, firms can design compensation packages
Chapter 14 Attracting and Retaining Qualified Employees 465
31“Ford sells Volvo to Chinese carmaker Geely for $1.5 billion,” NY Daily News (August 3, 2010), A. Latour (1999), “Detroit Meets a ‘Worker Paradise,’” The Wall Street Journal (March 3), B1.
that attract and retain qualified employees at the lowest cost. Firms sometimes can use the salary–fringe benefit mix to attract particular types of employees. For exam- ple, offering liberal insurance coverage is more likely to attract people with families than single individuals, who are more likely to prefer cash payments. Firms also have incentives to heed employee preferences when it comes to choosing the mix of fringe benefits. This incentive has motivated many firms to consider cafeteria-style benefits. Use of these plans is limited due to administrative costs and adverse-selection problems.
M. Aoki (1988), Information, Incentives, and Bargaining in the Japanese Economy (Cambridge University Press: Cambridge).
G. Becker (1983), Human Capital (University of Chicago Press: Chicago).
P. Doeringer and M. Piore (1971), Internal Labor Markets and Manpower Analysis (D. C. Heath: Lexington, MA).
R. Ehrenberg and R. Smith (2015), Modern Labor Economics: Theory and Public Policy, 12th edition, (Prentice Hall: Boston), Chapters 8, 9, and 11.
14–1. When Ford purchased Volvo AB’s car division in 1999, they had to decide what to do about the differences in the fringe benefits received by the employees. Although Ford plants have
fitness centers, these centers do not have the amenities offered at the Volvo plants such as
Olympic-size pools, badminton and tennis courts, tanning beds, and saunas. One reason for
the high level of fringe benefits at Volvo is the extremely high tax rates in Sweden. Company-
supplied services such as plush health facilities are not taxed by the government. However,
Ford employees in the United States might be tempted to argue for “perk parity” especially
during union contract negotiations.31
Suppose UAW negotiations argue for upgraded perquisites for Ford’s U.S. employees to
match those available in the Swedish plants Ford acquired from Volvo.
a. Ford might achieve perk parity by upgrading U.S. facilities or by reducing Swedish facilities. What would be the implications of each policy?
b. Ford might live with different levels of perks. What would be the implications? c. Suppose the difference in perks between U.S. and Swedish employees is reduced fol-
lowing the merger. What are the efficiency implications for the merger?
14–2. Consultants often spend much of their time away from home. Deloitte and Touche recently implemented a policy that curbs its consultants’ travel time. Instead of spending five days a
week at a client’s office, consultants spend three nights and four days, fly home, and work a
fifth day at their home cities. One observer argued that Deloitte and Touche is putting em-
ployee concerns ahead of good business. Deloitte and Touche should focus on company
profits, not employee comfort. Do you agree that the firm is necessarily wasting company
profits? Explain using concepts from class. In answering this question assume that employ-
ees would be more productive if they stayed at the client’s office.
Solutions to Self-Evaluation Problems 14–1. Ford and Volvo Perk Parity
a. If perks are increased by upgrading U.S. facilities (e.g., by adding saunas, etc.) costs will go up. Presumably, Ford was able to hire employees without the perks, and so there
is no obvious offsetting benefit to Ford. Reducing the perks in Sweden will lower the
pay of employees and make it more difficult to attract and retain employees (unless
Self-Evaluation Problems
Suggested Readings
466 Part 3 Designing Organizational Architecture
wages are increased). Presumably, the difference in perks between the two countries is
driven in part by taxes. Higher taxes in Sweden imply that it is best for companies to
pay higher fringe benefits/perks (which are not taxed) than is optimal in the United
States. Even if Ford wants to increase pay for U.S. employees, increasing perks is likely
to be an inefficient way to do so (they may cost Ford more than the value to the employ-
ees). The union understandably is focusing on the difference in perks, not the differ-
ences in salaries. International mergers involving companies with optimally different
compensation packages often generate these types of internal conflicts.
b. Ford can expect ongoing debates with the labor union over the differences. Also it can make it more difficult for the company to transfer employees between the two countries
because of the differences in the pay packages.
c. The result will be inefficient if Ford could design alternative pay package (such as those now in existence) that give the employees the same level of utility at a lower cost.
14–2. Corporate Travel Policy
Many employees do not like to be gone all week from their home (e.g., family concerns,
etc.). Employers that demand this behavior will have to pay a compensating differential to at-
tract and retain qualified employees. Reducing the time away from home reduces the com-
pensating differential. The cost savings may be greater than the loss due to the drop in pro-
ductivity. Thus, profits might increase from this change in policy.
14–1. Explain the following quotation: “My employer doesn’t determine my salary; he deter- mines where I work.”
14–2. In the basic competitive model, why do employees pay for general training and firms pay for specific training?
14–3. Why do firms form internal labor markets?
14–4. Evaluate the following statement: “Firms are free to set salaries in any manner they want in an internal labor market.”
14–5. Present an economic argument to explain why firms often have mandatory retirement (where allowed by law).
14–6. How do influence costs affect pay within internal labor markets?
14–7. The U.S. Congress has considered proposals that would limit the level of top executive pay to some multiple of the lowest-paid employee in the company (e.g., executive pay
must be less than 10 times that of the lowest-paid employee). Do you think this type of
proposal is a good idea? Explain what effect the proposal would have on the involved
companies.
14–8. President Clinton proposed eliminating the tax deduction for all compensation over $1 million for CEOs unless the pay is tied to company performance. Proponents argue that
this proposal will benefit shareholders. “Everyone knows that CEOs are overpaid and that
their pay is not appropriately tied to performance. This legislation helps solve both prob-
lems.” Present an argument against this proposal.
14–9. The Brown Tool Company is a multidivisional firm with offices throughout the country. The company sets the salaries of most of its positions at the central level. For example,
secretaries are paid $8 per hour throughout the company. Discuss two important reasons
why the firm might adopt such a policy. Discuss two important problems that the policy
might cause.
14–10. A recent study concluded that many employees fake sickness to avoid going to work. The authors argue that through unwarranted sick leave, employees “steal” about $150 billion a
year from firms. This amount is three times larger than the estimated loss from shoplifting.
One proposal is for Congress to outlaw the granting of sick leave to employees. The argu-
ment is that companies would be much better off because they would not incur the giant
Review Questions
Chapter 14 Attracting and Retaining Qualified Employees 467
losses associated with sick leave. Further, the costs of taking sick leave would be internal-
ized with the employees. Comment on this proposal.
14–11. The University of Rochester used to pay all faculty a 10 percent bonus as a substitute for a retirement plan. Individuals could either place this money in a retirement fund or keep the
cash. Placing money in the fund deferred taxes on the income until the point of with-
drawal. Changes in the U.S. tax code forced the university to change this policy. In particu-
lar, employees cannot be given options of this type but must be either covered or not cov-
ered as a group. The university now has the following policy: All new faculty members
without prior service at another university are given a 10 percent bonus in cash. This pay-
ment is treated as ordinary income for tax purposes. Most new faculty are young people
fresh out of graduate school. All faculty members with more than two years of service
must place the bonus in a retirement account. Taxes are deferred until withdrawal from the
account. Explain why it might make economic sense for the university to have such a two-
group plan, rather than treat all employees (old and new) the same.
14–12. The University of Medford pays the full tuition for the children of faculty members at any university in the world. Recently, this policy has received bad publicity. The argument has
been made that people in other occupations have to pay the tuition costs for their children
and so should college professors. According to this argument, it is not fair to have these
relatively well-paid people get subsidized in this manner. The board of trustees of the
University of Medford has been asked to reconsider this policy. Provide an economic
argument to explain why the board of trustees might want to continue this policy.
14–13. Payments under some retirement plans are based on the average earnings in the last few years of employment. Discuss the potential incentive effects of this policy.
14–14. Companies can often gain if they listen to employees about what they prefer in the way of a fringe benefit package—a more preferred package serves to attract and retain employees
at a lower cost. Nevertheless, many firms have shunned “menu plans” where each em-
ployee would be completely free to choose their own fringe benefit package. (For instance,
those wanting health insurance could buy it through the company, whereas those who want
some other benefit or cash would make different choices.) Why do you think many firms
have avoided this type of menu plan?
14–15. The Good Beer Brewing Company currently purchases health insurance for its 10,000 em- ployees. The company is considering a flexible plan where employees can have either
$2,000 in cash or insurance coverage (the insurance costs $2,000). The company figures it
will expend the same amount of money either way. However, employees will be better off
because they can choose the option that is most preferred. Do you see any potential prob-
lems with this idea? Explain.
14–16. Public accounting firms have traditionally paid low starting salaries to new employees. Nevertheless, these firms have been able to hire and retain qualified employees (even
though these employees could obtain higher salaries elsewhere). Is this observation incon-
sistent with economic theory? Explain.
14–17. People buying disability insurance on an individual basis are often required to take physi- cal exams. Physical exams are typically not required when employees acquire disability
insurance through a company-sponsored plan (which covers all employees in the firm).
Provide an economic rationale for the different policies relating to physical exams.
14–18. Marks & Spencer is a large, established British retailer of apparel, housewares, and food products. The company has a large workforce. As part of the company’s benefits package,
employees receive a discount of 30 percent off all purchases of apparel.
a. What are the advantages and disadvantages of offering a 30 percent discount off com- pany merchandise?
b. What are the advantages and disadvantages of offering a 30 percent discount off ap- parel, but not housewares and food products? Why do you think the company differen-
tiates between apparel and other products?
468 Part 3 Designing Organizational Architecture
14–19. A recent study found that CEOs in Europe are paid substantially less than CEOs in America, even after controlling for a firm’s size and industry. Does this necessarily imply
that American CEOs are overpaid? Explain.
14–20. Consider two states that are nearly identical in terms of such factors as income, climate, and population. There are public universities in both states. One state has a law which
specifies that all professors of a given rank (assistant, associate, and full professor) have to
be paid the same. Thus an assistant professor, whether in history or in law, has to be paid
the same. Associate professors are paid more than assistant professors. However, all asso-
ciate professors have to be paid the same. The same is true for full professors. The other
state does not have such a law. In this state, law professors are paid substantially more than
history professors within each rank. The laws in both states allow the universities to
choose their own teaching loads for faculty. These loads can vary across faculty members.
a. How do you expect the teaching loads to vary across the two states (you can focus on history and law departments)? Explain the economic reasoning behind your answer.
b. Are either history or law professors in the state with the law necessarily better or worse off than their counterparts in the state without the law? Explain.
c. Discuss how the residents of the state might be made worse off by such a law.
14–21. Some companies base promotions solely on seniority. Discuss the negative and positive as- pects of such a policy.
14–22. Building on the discussion in Chapter 3 on minimum wage laws, how would you expect a large increase in the minimum wage to affect the pay package (mix between salary and
benefits) offered by employers?
chapter
15 C H A P T E R O U T L I N E
The Basic Incentive Problem
Incentives from Ownership
Optimal Risk Sharing
Effective Incentive Contracts
Principal-Agent Model
Informativeness Principle
Group Incentive Pay
Multitasking
Forms of Incentive Pay
Incentive Compensation and Information Revelation
Selection Effects of Incentive Contracts
Does Incentive Pay Work?
Summary
Appendix: Multitasking Theory
I n October 1988, DuPont’s fibers division announced “one of the most ambitious pay-incentive programs in America.”1 Its plan covered nearly all of the division’s 20,000 employees—both management and rank-and-file employees. Under the plan, a portion of employees’ pay
would be placed into an “at-risk pool.” If the business exceeded its profit goals for the year, the employees would receive a multiple of the at-risk monies as a bonus. If not, the employees stood to lose the money in the pool. The intent was eventually to place as much as 6 percent of annual pay at risk. The plan initially was adopted for a three-year trial period. Many companies indicated that they were watching this experiment carefully to see what they could learn about incentive pay. “The attention that the American business community has given to the DuPont program is tremendous,” said Robert C. Gore, a vice president at Towers Perrin Company—a major compensation consulting firm.
The largest of DuPont’s chemical businesses, the fibers division comprises departments ranging from automobile seat covers to apparel. In 1990,
Incentive Compensation
L E A R N I N G O B J E C T I V E S
1. Define the basic incentive problem. 2. Describe optimal risk sharing and how ownership mitigates the incentive
problem.
3. List the important trade-offs in effective compensation plans. 4. Explain the basic principle-agent model and the associated list of factors that
favor high incentive pay.
5. Define the informativeness principle. 6. Summarize the potential benefits and costs of group incentive compensation
plans.
7. Discuss the multitask principal agent problem and its implications. 8. Identify the various forms of incentive pay. 9. Describe how incentive compensation can be used to cause employees to reveal
their private information.
10. Discuss the controversy surrounding incentive pay.
1Details of this example are from L. Hays (1988), “All Eyes on DuPont’s Incentive Program,” The Wall Street Journal (December 5), B1; and R. Koening (1990), “DuPont Plan Linking Pay to Fibers Profit Unravels,” The Wall Street Journal (October 25), B1.
470 Part 3 Designing Organizational Architecture
the division had to achieve a target of 4 percent real-earnings growth for its employ- ees to recover their at-risk pay. But profits for the first nine months were off 26 per- cent, due largely to a poor economy and unexpectedly high input prices. Demand for the division’s products had declined substantially due to weak housing and automo- bile markets, and oil prices had risen materially because of the Gulf War. By fall 1990, it was obvious that the employees were likely to lose all the monies placed in the bonus pool. Employee discontent was quite high: Employees were facing signif- icant financial losses, largely due to factors beyond their control. In October 1990, DuPont precipitously canceled the incentive program with more than a full year left in the trial period. In the words of the fibers division chief, “I have to conclude it was an experiment that didn’t work.”
Given the widespread interest in this experiment, it is important to understand why the DuPont plan failed. Incentive pay, as some critics claim, simply might be a bad idea. If so, any firm adopting a large-scale incentive plan is making a mistake and should expect to experience a fate similar to DuPont’s. Alternatively, the failure of this plan might be traced to basic design flaws that could have been avoided through more careful planning. In this chapter, we examine the economics of incen- tive compensation. Our analysis suggests that DuPont’s failure was due largely to problems with the structure of its plan. Correspondingly, our analysis provides insights into how companies might design more effective compensation plans.
We begin this chapter by providing a more detailed discussion of incentive problems. We then examine how ownership can resolve some of these problems by providing strong incentives for individuals to take efficient actions. Next, we con- sider a critical limitation of ownership in controlling incentive problems—inefficient risk bearing. We then detail the implications of risk bearing for the design of compensation contracts. Next, we review some of the key insights about incentive compensation contained in the economics literature. We begin by discussing the standard principal-agent model. We then extend this basic analysis by considering the informativeness principle, group incentive pay, multitasking, alternative forms of incentive pay, and the role of incentive pay in the process of matching individuals with jobs. Toward the end of the chapter, we discuss the debate on whether incentive pay works, and we provide a case study on CEO compensation to allow the reader to apply some of the concepts we develop on compensation policy. In the appendix we examine multitasking problems in greater detail.
The Basic Incentive Problem Incentive problems exist within firms because owners and employees have funda- mentally different objectives. For example, the owners of an insurance company want its salespeople to sell insurance policies to customers, but salespeople might prefer to play golf. Similarly, stockholders of a research company want its scientists to develop marketable products, whereas scientists might prefer to work on more intellectually challenging but less marketable ideas. Presumably, employees at DuPont’s fibers division have other interests than simply making and selling fibers products.
Consider the example of AssemCo, a small company that assembles components for several large electronics firms. As in most companies, there is a basic conflict be- tween the aims of the owners and the aims of the employees. The owners would like employees to work diligently, but the employees would prefer longer coffee breaks and working at a more leisurely pace.
Chapter 15 Incentive Compensation 471
To add concreteness to our discussion, we focus on the problem of motivating a particular employee at AssemCo, Ian MacLeod. For simplicity, we focus on a given time period (e.g., motivating Ian over a single week). Ian’s preferences with respect to income and work are portrayed by the following utility function:2
U � I � e 2 (15.1)
where I is his income for the period and e is the number of units of effort exerted (e.g., hours spent actually assembling components). This utility function, which measures utility in dollar equivalents, indicates that he is better off as his total in- come increases but becomes worse off as he exerts more effort on component as- sembly. As Ian exerts effort, he suffers decreased utility because he would rather en- gage in other activities. His reservation utility is equivalent to $1,000. AssemCo must meet this level of utility or Ian will not work for the firm.
As Ian exerts more effort, he assembles more units, and this benefits the firm. The benefits to AssemCo from his effort are
B � $100e (15.2)
To begin with a simple case, suppose that his effort is costlessly observable and verifi- able—hence, effort is contractible. In this case, the firm offers Ian a compensation contract that would pay him a sum of money if, and only if, he provides a specified level of effort, ê. He will accept this contract, so long as he is paid his reservation -utility. To meet this condition, the firm must pay him a wage of $1,000 � ê2. If he delivers that level of effort and is paid $1,000 � ê2, then his utility is U � ($1,000 � ê2) � ê2 � $1,000 and he receives his reservation utility. The profits to the firm � from his efforts are
� � $100ê � ($1,000 � ê2) (15.3)
The firm then chooses the ê that maximizes the firm’s value. Figure 15.1 provides a graphical illustration of this problem. The figure displays
both the benefits to the firm ($100e) and the costs ($1,000 � e2). Profits are the differ- ence between the two. As the figure indicates, maximum profits occur at e* � 50. At this effort level, Ian is paid $3,500 and the profits for AssemCo are $1,500. This out- come is the efficient bargaining solution. Ian is indifferent among the feasible effort choices—he is paid his reservation wage in all cases—and the firm’s profits are maxi- mized at 50. The firm could induce him to provide additional effort by paying him more. However, the additional costs to the firm would exceed the incremental benefits. At the optimal effort level of e* � 50, the marginal costs of effort are equal to the mar- ginal benefits; hence relevant benefits and costs to both parties are considered.3
Thus far, we have assumed that Ian’s effort is costlessly observable. But this is rarely the case. Effort normally is observable neither by the firm nor by a court of law—effort is not contractible. In addition, the firm is unlikely to be able to tell whether Ian worked hard simply by observing his output. Sometimes, output is
2We chose this particular utility function (as well as the firm’s benefit function, discussed below) to simplify
the calculations. Our basic results, however, are quite general and are not specialized to this particular
example. 3Technical note: Recall that the marginal benefit at a point is equal to the slope of the total benefit at that point.
The same relation holds between marginal cost and total cost. Using elementary calculus, the slope of the
total cost curve is 2e, whereas the slope of the total benefit curve is 100. The optimal effort level is where they are equal or 2e � 100; thus e* � 50.
472 Part 3 Designing Organizational Architecture
difficult to measure and is affected by factors beyond the employee’s control.4 In this case, there is a standard incentive problem. If Ian promises to provide 50 units of ef- fort and is paid a fixed salary of $3,500, he has the incentive to renege on his promise and provide less effort. He gets paid anyway and benefits from exerting less effort. The firm might suspect that Ian did not work hard. However, it would not know for sure. In this case, a straight salary of $3,500 fails to provide Ian with appropriate in- centives. Rather, AssemCo must devise some other type of contract that motivates him to provide additional effort.
This simple example illustrates three important points about incentive problems:
• If the interests of employees and employers were aligned perfectly, there would be no reason to worry about incentives. Incentive problems exist basi- cally because of conflicts of interest between employers and employees.
$
1,000
3,500
5,000
Level of effort
e* � 50 e
Costs of effort: $1,000 + e 2
Benefits of effort: $100e
Firm profit = $1,500
B e n e fit
s a n d c
o st
s (i n d
o lla
rs )
Figure 15.1 The Optimal Effort Choice at AssemCo
This figure pictures both the benefits and the costs to AssemCo from the efforts of a given employee, Ian MacLeod. Profits are the difference between the two. Maximum profits occur at e* � 50. This example assumes that Ian will exert the agreed-upon effort as long as he is paid his reservation utility. To meet this constraint, the firm must pay a wage of $1,000 � e2. This payment meets Ian’s reservation wage of $1,000 and reimburses him for his disutility of effort. Benefits to the firm are $100e. At the optimal effort level, e* � 50, $5,000 in gross benefits are generated. Ian is paid $3,500 and the firm’s profits are $1,500. The firm could induce Ian to exert more effort by paying him more. However, the costs are larger than the benefits. The effort choice of 50 is efficient. Ian is indifferent among the possible choices (since he is paid his reservation utility in each case), and the profits for the firm are maximized at this level.
4In our simplified example, the firm can infer e from observing Q, Ian’s output. More generally, Q would be affected by factors that are beyond the control of the employee. For example, the following relation might
hold: Q � $100e � �, where � is a random error. Random factors that might affect his output include the quality of raw materials and equipment failures. With the random error term, the firm cannot infer e simply from observing Q.
Chapter 15 Incentive Compensation 473
• Incentive conflicts do not cause problems when actions are contractible. Firms can identify the most efficient actions and pay employees only if those actions are taken. For instance, if the actions of employees at DuPont were costlessly observable, there would be no reason for the firm to adopt a profit-based plan for employees. Rather, the employees could be motivated appropriately by contracts based directly on their actions.
• In choosing the optimal action, there is a trade-off between the benefits of the action for the firm and the personal costs borne by the employees. In a com- petitive labor market, employees must be compensated for undertaking unde- sirable actions—there are compensating differentials. It normally is not sensi- ble to have employees work as hard as physically possible.
Incentives from Ownership
In special cases, there is a simple way to resolve incentive problems, even when the actions of employees are unobservable. This solution is to sell each employee the rights to his or her total output. The incentive problem is caused by the fact that most of the costs of exerting effort are borne by employees, while much of the gains go to the owners. By selling employees their output, both the benefits and costs of exert- ing effort are internalized by employees and thus employees will make more pro- ductive choices. For instance, in our AssemCo example, the firm could sell Ian the rights to the value of his output ($100e) for a price of $1,500. AssemCo makes the same profits as when effort was costlessly observable. Ian’s objective, in turn, is to maximize his personal utility given by
U � ($100e � $1,500) � e 2 (15.4)
where the first term represents the income from exerting effort (the value of the out- put minus the $1,500 payment to the company) and the second term represents the disutility of effort. Given this problem, Ian will choose to exert 50 units of effort and will have utility of $1,000.5 This outcome is the same as in the perfect information case. It is achieved even though the employer cannot observe Ian’s effort.
This discussion highlights the strong incentive effects that come from ownership. In practice, ownership often is used as an incentive mechanism. For example, a majority of the businesses in the United States are private. Moreover, the last 30 years have wit- nessed a large number of managerial buyouts of public firms and divisions of public firms, where the managers went from the status of employees to owners. Although some aspects of these buyouts might be controversial, the evidence indicates that the managers have operated the units more efficiently after they became owners.6 Further- more, about one-third of all retail sales in the United States are made through franchised outlets (including car dealers and gas stations). In franchising, the future profits of each unit are sold to franchisees, who as owners have strong incentives to maximize value.7
5Technical note: This solution can be found using elementary calculus (see footnote 3) or a graphical analysis,
as in Figure 15.1. We present a more detailed analysis of the employee’s effort choice later in this chapter. 6S. Kaplan (1989), “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Financial Economics 24, 217–254.
7J. Brickley and F. Dark (1987), “The Choice of Organizational Form: The Case of Franchising,” Journal of Financial Economics 18, 401–420. In many franchise agreements, the central company receives an ongoing sales royalty from the franchisee. This royalty provides incentives to the central company to honor
commitments on training and promoting the brand name. The franchisee’s claim on future profits is typically
limited to some time period—for example, 20 years. The contract often is renewable.
474 Part 3 Designing Organizational Architecture
At least three important factors limit the use of ownership in resolving incentive problems:
• Wealth Constraints. Limited wealth can make the ownership solution infea- sible. For instance, although senior managers at DuPont might have stronger in- centives if they owned the company, few management groups have access to sufficient capital to finance this purchase.
• Risk Aversion. Typically, employees do not have full control over their out- puts. Rather, output depends on random outside events in addition to employee efforts. For example, DuPont’s profits are affected by changes in the oil, hous- ing, and automobile markets. In making employees fully accountable for their actions, ownership also exposes them to random events that affect their output but are beyond their control. Given that employees do not like to bear risk, em- ployee ownership entails a risk-bearing cost (see Chapter 2). As we discuss below, this cost must be considered in designing incentive contracts.
• Team Production. In most firms, there are production synergies; total output is greater than the sum of what each employee could produce individually. Identifying the separate contributions when there is this type of team produc- tion is problematic. Even if the firm were owned jointly by the employees, it would not solve this basic incentive problem—there still would be the free- rider problem discussed in Chapter 10.
Optimal Risk Sharing
To illustrate some of the basic principles of efficient risk sharing, consider an exam- ple, Abby Ross receives a monthly income from a trust fund. Depending on the per- formance of the fund, this income can be either $0 or $10,000, each with a probabil- ity of .5. Abby’s expected income is $5,000.8 However, the income stream is risky—half the time, Abby gets $0. Jess Rogers also has a trust fund with the same income possibilities. Half the time he gets $0; the other half, $10,000. The income flows for Abby and Jess are independent. (That is, regardless of the outcome for Abby, the probability is still .5 that Jess will get $0.)9 The left column of Table 15.1 displays the joint distribution of outcomes for Abby and Jess.10 The probability of each outcome is given in the middle column.
Assuming that Abby and Jess are risk-averse (holding expected income constant, the person prefers less dispersion in outcomes), they both can be made better off by agreeing to split their combined incomes. The possible payoffs for each individual are given in the right column of Table 15.1. The expected income per individual is still $5,000. By sharing the risks, however, the variability of their individual incomes has been reduced. The variability is reduced because the likelihood that both Jess and Abby will be lucky or unlucky is less than the likelihood that only one of them is
8The expected income is the average amount that Abby will receive in a month. It is calculated by adding together each possible income multiplied by the respective probability: ($10,000 � .5) � ($0 � .5) � $5,000.
9We assume that the flows are independent to simplify the calculations in the example. The basic insights of
this analysis hold as long as the two flows are not perfectly positively correlated. 10A joint outcome ($X, $Y) refers to Abby receiving X dollars while Jess receives Y dollars. Since the events
are independent, the probability of any joint outcome is the probability of the first event (that Abby receives
$X) multiplied by the probability of the second event (that Jess receives $Y). For example, the probability that both will receive $0 is .5 � .5 � .25.
Chapter 15 Incentive Compensation 475
lucky. For example, by sharing the risks, the probability of getting nothing is only .25, compared to .5 with no risk sharing. Being risk-averse, they prefer the less volatile income stream. (Ideally, they would like income streams that are certain.) It is this reduction in volatility from pooling risks that drives individuals to purchase insurance, as well as to invest in diversified portfolios—for example, mutual funds.
People often differ in their attitudes toward risk. Some people are more willing to tolerate large financial risks, whereas others are not. An efficient allocation of risk takes these differences in preference into account. For example, suppose that Jess is risk-neutral, whereas Abby is risk-averse. (A risk-neutral person cares only about the expected payoff and does not care about the dispersion in potential values around that expected value.) Jess will value each of the two random income flows at $5,000 (the expected value), whereas Abby will not. For example, Abby might be willing to accept a certain payment of $4,000 for her risky income flow. Here, there are gains from trade by having Jess buy Abby’s income. A payment of $4,500 would split the potential gains of trade between the two parties. Each party would be better off by $500.
The common stock of large corporations typically is owned by many investors, each holding well-diversified portfolios. Because of this diversification, investors are less concerned about the fortunes of any one company. (Things that are specific to in- dividual firms tend to average out over their entire portfolios; i.e., one firm is lucky, whereas another firm is unlucky.)11 Employees, in contrast, receive large fractions of their incomes from their individual employers (each generally has but one job), and thus they care greatly about the fortunes of individual firms. This difference in outlook simply reflects the fact that employees of a firm have less effective methods to manage firm-specific risk than the firm’s shareholders. (We are not saying that
Joint Outcomes Probability Individual Payoffs from Splitting
($0;$0) .25 $ 0 ($0;$10,000) .25 5,000 ($10,000;$0) .25 5,000 ($10,000;$10,000) .25 10,000
E(Income) � $ 5,000
Table 15.1 Example of Risk Sharing
In this example, two people receive incomes from different trust funds. Each fund pays either $0 or $10,000, each with a probability of .5. The two funds have independent payoffs. The left column displays the possible joint payoff outcomes, and the middle column shows the probability of each outcome occurring. For instance, ($0;$0) is the outcome where both funds pay $0 for the period. The probability of this outcome is .25. The right column shows the individual incomes if the two people agree to split the payoffs from the two funds. Splitting the payoffs makes both better off, compared to relying solely on the payoffs from their individual funds. The expected income in either case is $5,000. However, risk is reduced by the pooling of the funds. For instance, each person has a .5 chance of receiving no income when keeping all the income from his or her own fund. The two people only have a .25 chance of receiving no income when they pool the funds.
11For example, H. Markowitz (1959), Portfolio Selection ( John Wiley & Sons: New York); and W. Sharpe (1964), “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19, 179–211.
476 Part 3 Designing Organizational Architecture
employees have different preferences than owners; rather, it is their ability to manage risk through well-diversified portfolios that makes shareholders in large corporations more willing to bear such risk.)
Assuming that the shareholders of the firm can manage firm-specific risks more effectively than employees, they will be willing to bear these risks at a lower price. Thus, it is better from a risk-sharing standpoint to pay employees fixed salaries and let the total risk of random income flows be borne by the shareholders. By paying fixed salaries, the firm avoids having to pay a compensating differential for risk bear- ing to attract and retain the desired workforce.
Effective Incentive Contracts Our discussion to this point suggests that compensation contracts serve at least two important functions. First, they are used to motivate employees. Second, they are used to share risk more efficiently. Un- fortunately, there is a trade-off between these two objectives. Efficient risk sharing suggests that it is better to pay employees fixed salaries,
while incentive considerations suggest that it is better to tie pay to performance. An effective compensation contract strikes an appropriate balance between these two considerations.
• When the owners of a firm have a comparative advantage in bearing firm- specific risks, it is better from a risk-sharing standpoint to offer employees more fixed salaries and let more of the risk of random income flows be borne by owners (e.g., shareholders in large corporations).
• Fixed salaries do not provide strong incentives. Incentives are provided by bas- ing pay on performance.
• The previous two points indicate that there is a trade-off between paying in- centive compensation to increase effort and the associated costs of inefficient risk bearing. Often, an effective contract consists of a fixed salary and one or more variable components based on performance.
Economists have devoted substantial effort to studying how to design effective compensation contracts. In this section, we summarize some of the more important findings from this research. We begin with the most basic model in the economics lit- erature, the standard principal-agent model. This model considers a contracting situ- ation that closely resembles our example of Ian MacLeod of AssemCo. However, the model generalizes this example and focuses on choosing the optimal contract when the employer cannot observe the employee’s effort. Following the introduction of the basic model, we extend the analysis by considering the informativeness principle, group incentive pay, multitasking, types of incentive pay, and the role of incentive pay in self-selection.
Principal-Agent Model
The Basic Model Economic analysis of incentive compensation begins with the basic principal-agent model.12 This model presents a relatively simple characterization of the contracting
Basic Principle Important trade-offs exist between incentives and risk sharing.
12One of the first presentations of this model is B. Holmstrom (1979), “Moral Hazard and Observability,” Bell Journal of Economics 10, 74–91.
Chapter 15 Incentive Compensation 477
process, illustrates the trade-offs between risk sharing and incentives, and provides a number of useful insights for designing more effective compensation plans. In this single-period model, there is an employer (the principal) who wants the employee (the agent) to work on the employer’s behalf. The employer is risk-neutral, while the employee is risk-averse. The most basic analysis focuses on an individual employee. Concerns about teamwork do not arise within the basic model.
Consider the example of Erica Olsson of a biotech firm, DNAcorp. Erica’s output Q is a function of her effort, plus some random effect, � (with expected value 0 and variance, �2):
Q � �e � � (15.5)
where output is defined as the market value of her production. The model does not consider the possibility that Erica might manipulate the observed output level (e.g., by “cooking the books”). Both Erica and her supervisor, Jon Chang, can observe her output.
If Erica increases effort by one unit, output goes up by � dollars. Thus, � is Erica’s marginal productivity—the higher the �, the higher her marginal productivity. The random effect � reflects factors that can affect output but are beyond Erica’s control (e.g., equipment failures). The higher �2, the more likely it is that the output will ex- perience larger random shocks.
Optimal risk sharing suggests that there are benefits from having the owners of the DNAcorp bear the output risk and pay Erica a fixed salary. For example, Erica might agree to put forth effort level ê and be paid a fixed salary W for this effort. The own- ers of DNAcorp receive the difference between the value of the output and W.
Owners’ profits � (�ê � �) � W (15.6)
There is, however, an incentive problem with this arrangement if Erica’s supervi- sor can observe neither her effort level nor �, the random shock. Erica has the in- centive to agree to ê as an effort level but then to exert less effort. Jon will tend to ob- serve lower output when she shirks. However, Erica always can claim that her low output was due to bad luck—that is, � was negative.
Employee’s Effort Problem Incentives can be provided to Erica by basing part of her compensation on realized output. For example, consider Erica’s incentives under the following contract:
Compensation � W0 � �Q (15.7)
where 0 � � � 1. This contract pays Erica a fixed wage W0, plus a proportion � of the output Q.13 To illustrate Erica’s effort choice, suppose W0 � $1,000, � � .2, Q � $100e � �, and C(e) � e2, where C(e) is Erica’s cost of effort in dollar equivalents. Given these values, the compensation contract is
Compensation � $1,000 � .2($100e � �) (15.8)
13For simplicity, we restrict our attention to linear compensation contracts. One justification for focusing on
linear contracts is that in practice they are observed commonly. For instance, salespeople and real estate
agents often are paid commissions, while factory employees frequently are paid piece rates. Linear contracts
have the advantage of providing consistent incentives to the employee that do not depend on past output (the
marginal payoff for increasing output by one unit is constant). In contrast, lump-sum bonuses that are paid
once some threshold is reached lose their incentive effects once the target is met. For a technical justification
for linear contracts, see B. Holmstrom and P. Milgrom (1987), “Aggregation and Linearity in the Provision
of Intertemporal Incentives,” Econometrica 55, 303–328.
478 Part 3 Designing Organizational Architecture
The benefit to Erica from exerting effort is that it increases compensation—each unit of effort increases her compensation by $20 (.2 � $100). Random shocks � affect total compensation but do not affect the benefits of exerting effort. For any realization of �, compensation is always $20 higher for every extra unit of effort provided. Thus, in choosing the optimal effort level, Erica can ignore �. (It does not affect the costs or benefits of her effort.)14 Erica’s cost from exerting effort is e2. Her objective is to choose the effort level that maximizes her net benefits.
Figure 15.2 depicts how Erica’s compensation and personal costs increase as she exerts more effort. As shown in the figure, the optimal effort choice is 10. Note that this figure displays Erica’s total costs and benefits. Her marginal benefits and mar- ginal costs at any effort level are equal to the slopes of the total curves at that point. The difference between total costs and benefits is greatest when the slopes of the total curves are equal. Thus, at the optimal choice (e* � 10), the marginal costs of effort are equal to the marginal benefits, and net benefits are maximized. If Erica ex- erts more than 10 units of effort, the extra income is insufficient to compensate her for the extra disutility she experiences from exerting more effort. When e is less than 10, Erica is made better off by exerting more effort, since the additional compensa- tion is more than sufficient to cover the added costs of her additional effort.
$
1,200
e
Level of effort
e* � 10
Costs: e 2 Compensation: $1,000 + $20e
C o
st s
(i n
d o
lla rs
)
Figure 15.2 The Employee’s Effort Choice
This figure shows how the compensation and personal costs increase as the employee exerts more effort. The compensation function is $1,000 � $20e. The employee’s cost function is e2. The objective of the employee is to choose the effort level that maximizes the net benefits. This maximization occurs at e* � 10. At this point, the marginal benefits of effort ($20) are equal to the marginal costs. The employee’s expected compensation is $1,200.
14Technical note: Throughout our analysis, we assume that Erica’s attitude toward risk does not change with
her level of wealth. Relaxing this assumption means that she will consider an additional effect in choosing
the effort level. In particular, the effort choice will affect her utility by altering the costs imposed on her from
bearing risk. We ignore this potential effect because it complicates the analysis without providing
substantially more insights.
Chapter 15 Incentive Compensation 479
Figure 15.3 depicts how Erica’s effort choice changes with changes in the fixed wage W0 and the incentive coefficient �. Changing the fixed wage from $1,000 to $2,000 results in a parallel shift in compensation, but Erica still chooses e* � 10.15
The higher fixed wage provides no incentives for her to work harder since it does not affect the marginal benefits of effort. Marginal benefits are $20, regardless of the fixed wage. In contrast, when the incentive coefficient is increased, Erica selects a higher effort level. For instance, with � � .3, Erica selects 15 units of effort. In this case, marginal benefits increase to $30 and she exerts more effort.
The implications of this analysis should be contrasted with the common argument that well-paid employees work harder because they are happier on the job. In our analysis, higher pay does not provide incentives unless it is tied to good performance. It is important to note that our analysis focuses on a single time period. In a multi- period setting, a high level of pay can motivate employees if the likelihood of being fired is contingent on performance. (See the discussion in Chapter 14 on efficiency wages—in this case, the threat of dismissal effectively ties pay to performance.) But high pay and guaranteed tenure with the firm would provide no incentive effects.
The Optimal Contract We have shown how Erica will choose effort under different compensation contracts. The firm’s problem is to choose the specific compensation contract that maximizes
15We assume that the additional wage does not change Erica’s trade-off between income and leisure.
$
e
Level of effort
C o
st s
(i n
d o
lla rs
)
2,000
1,000
10 15
b = .2 (Intercept change)
b = .3 (Slope change)
b = .2 (Original contract)
Figure 15.3 How the Employee’s Effort Choice Changes with Changes in the Fixed Wage and Incentive Coefficient
The initial contract is Compensation � $1,000 � .2($100e). The picture shows that increasing the fixed wage from $1,000 to $2,000 causes a parallel shift in the compensation function but does not alter the optimal effort choice (it stays at 10). Changing the incentive coefficient � from .2 to .3 changes the slope of the line and increases the optimal amount of effort to 15.
480 Part 3 Designing Organizational Architecture
expected profits, given Erica’s anticipated effort choice. The primary choice variable is the incentive coefficient, �. Given this choice, W0 can be adjusted up or down to meet Erica’s reservation utility. Selecting a contract with a high �, benefits the owners of the firm because it increases Erica’s effort. However, choosing a high � also imposes costs on the firm. The expected compensation that the firm must pay to Erica increases with � for two reasons. First, as discussed above, Erica must be compensated for exerting more effort. Second, increasing � imposes additional risk on her—the variable portion of her compensation increases. As risk increases, so does the compensating differential that must be paid to induce Erica to remain with the firm. The optimal contract involves an appropriate balancing of these costs and benefits.
Implications Employees normally are offered an incentive contract that implies less effort than would be required if the employer could costlessly observe the effort choices. When effort is unobservable, the employer could elicit ê by paying sufficiently high incen- tive pay. But with high incentive pay, the employee is forced to bear more risk. And we know that risk-averse employees must be compensated for bearing risk. In de- signing incentive contracts, the employer must balance the additional output from the higher effort that incentive contracts induce against the larger compensating differen- tial for risk bearing. Hence, compensation contracts that have high levels of incentive pay to induce the agent to exert the effort level that maximizes firm value when effort is observable (ê) are likely undesirable after taking into consideration the additional risk premium required to compensate the employee for bearing so much risk.16
Our analysis suggests five factors that are likely to be important in selecting how strongly pay should be tied to performance. These factors are summarized in Table 15.2. The first factor is the sensitivity of the value of the output to additional effort from the employee. In our example, this factor is captured by �—Erica’s mar- ginal productivity. A high � implies that incentive pay (holding other factors
16The basic model assumes that the employer has the relevant knowledge to solve this problem, including
knowledge of the production function, the employee’s utility function, and the variance of the random error
term. For a mathematical derivation of the results in this section, see Chapter 7 of P. Milgrom and J. Roberts
(1992), Economics, Organization, and Management (Prentice Hall: Englewood Cliffs).
Factors That Favor High Incentive Pay
1. The value of output is sensitive to the employee’s effort. 2. The employee is not very risk-averse. 3. The level of risk, that is, beyond the employee’s control is low. 4. The employee’s response to increased incentives is high (the employee exerts substantially
more effort). 5. The employee’s output can be measured at low cost.
Table 15.2 Implications of the Principal-Agent Model
The model suggests that the five factors listed are likely to be particularly important in determining how strongly to base pay on performance.
Chapter 15 Incentive Compensation 481
constant) is effective because the benefits of motivating effort are high. A second fac- tor is the risk aversion of the employee. Higher risk aversion implies a higher cost from inefficient risk bearing and thus reduces the use of incentive pay. The third fac- tor is the level of risk, that is, beyond the employee’s control (�2). When the level of risk is low, output is determined primarily by the employee’s effort and it makes sense to pay higher levels of incentive compensation. But when this risk is high, in- centive compensation imposes high costs for inefficient risk bearing. The fourth fac- tor is how much additional effort the employee exerts as incentives are increased. If the employee is unresponsive to increased incentives, high incentive compensation imposes more risk on the employee while inducing little additional effort. Thus, there is less reason to provide high incentive pay. The responsiveness to incentive pay depends on the personal costs to the employee for exerting additional effort. For instance, changing the cost function in Figure 15.3 from e2 to e3 would make Erica less responsive to changes in incentives. With the original cost function, Erica in- creases effort by 5 units as � is increased from .2 to .3. But the increase is only .58 under the second cost function.17 Finally, our analysis presumes that Erica’s output can be observed costlessly. This is not always the case. The more expensive it is to measure her output, the less likely that she will be offered incentive pay. We discuss these measurement cost issues further in the next chapter.
DuPont Revisited The principal-agent model suggests at least two problems with the DuPont plan. Both problems stem from using divisional profits as an output measure. First, under the plan, individuals bear the full costs of their own effort but realize only a small fraction of the output of their effort—it is shared with 19,999 other employees ( � is quite small for individual employees). The limited incentives are due to the basic free-rider problem discussed in Chapter 10. We discuss this issue in greater detail later in this chapter under the topic of group incentives. The second problem is that divisional profits are affected by many random factors (�2 is high), as well as the ef- fects of other employees throughout the division. Thus the compensation plan imposes substantial uncontrollable risk on the employees. DuPont would have provided more effective incentives if it had paid the employees based on disaggregated output measures over which they had greater control—in the limit, their own output.
Using Incentive Pay A study of 64,174 individual workers in 369 Finnish metal firms finds that piece-rate-based pay schemes are mostly
used in small firms and in less complex tasks. Piece rates are usually adopted where the worker’s output is easily
observable, and hence where monitoring costs are low. The decision to adopt piece rates is also used to attract high-
ability workers, and workers more willing to exert high effort. The study further reports that employees paid via piece
rates earn much higher wages than the workers paid under fixed rates. Finally, when workers change from fixed-rate
contracts to piece-rate contracts, they work for more hours.
Source: T. Pekkarineny and C. Riddell (2008), “The impact of piece rate contracts on wages and worker effort: Evidence from linked
employer-employee data,” ILR Review (April), 297–319.
A C A D E M I C A P P L I C AT I O N S
17Technical note: It is the second derivative of the cost function, that is, important in determining the response
rate: Larger second derivatives (or equivalently steeper marginal cost curves) translate into lower response
rates.
482 Part 3 Designing Organizational Architecture
Informativeness Principle18
As we have seen, incentive problems exist because of imperfect in- formation. If the actions of employees were observable at zero cost, it would be easy to write contracts to motivate appropriate behavior. It follows that the inefficiencies that result from incentive problems can be reduced by improvements in information. The standard prin- cipal-agent model assumes that there is only one indicator of an em- ployee’s effort, the employee’s output. In many cases there are other sources of information that can be used to determine whether or not the employee worked hard. For instance, DuPont was able to tell that the decline in profits in 1990 was not due entirely to a lack of effort on the part of divisional employees by observing the increase in the price of oil and the performance of other companies as well as by gathering information such as government reports on general busi- ness conditions. Appropriate use of this type of information increases the precision by which employee effort is measured and, when in-
cluded in the compensation contract (with the appropriate weights), reduces the costs of inefficient risk bearing. In theory, it is optimal to include all indicators that provide additional information about the employee’s effort in the compensation contract— assuming the measures are available at low cost.19 This basic idea is called the informativeness principle.
One important source of information about an employee’s effort level is the out- put of coworkers performing similar tasks. For instance, if a salesperson’s perfor- mance is poor in a given year, was the person unlucky or lazy? If average sales in the company declined substantially over the same time period, it is more likely that the employee was simply unlucky. If other salespeople had great years, the salesperson is more likely to have been lazy. The informativeness principle implies that informa- tion about other employees’ sales should be included in the compensation contract as a benchmark—that is, the firm should employ a relative performance contract. Chapter 16 provides an extended discussion of relative performance evaluation and highlights several potential problems that can make relative performance evaluation undesirable.
The informativeness principle indicates that it typically is beneficial to include low-cost indicators in the compensation contract that improve the employee’s per- formance measure. It also can be desirable for the firm to expend additional re- sources on developing even more precise measures of performance. Here, there is a trade-off between the costs of developing as well as implementing better perfor- mance measures and the benefits of improved effort motivation and more effective risk sharing.
The informativeness principle suggests that DuPont could have reduced the risk imposed on the employees by including other indicators in the contract. For instance, rather than use an absolute performance standard (such as 4 percent real earnings growth), the target could have been set relative to the growth of other firms in the
Basic Principle: Informativeness Principle In designing compensation con- tracts, theory suggests that it is productive to include all perfor- mance indicators that provide additional information about the employee’s effort (assuming the measures are available at low cost). Measuring the employee’s effort with more precision reduces the costs of inefficient risk bearing and leads to a more efficient effort choice.
18Material in this section draws on B. Holmstrom (1982), “Moral Hazard in Teams,” Bell Journal of Economics 13, 324–340.
19It is important to consider how simple or complex this relation is. To motivate employees, they have to
understand the relation between their actions and their payoffs. If the plan gets so complicated that this link
is broken, a simpler plan may be more effective.
Chapter 15 Incentive Compensation 483
same industry. This type of contract might have avoided some of the problems that the company faced in 1990, when employees were likely to lose money under the plan due to circumstances beyond their control.
The informativeness principle also suggests that DuPont could have reduced the uncontrollable risk imposed on its employees by adjusting earnings to reflect exter- nal changes in market conditions. For example, the company could have adjusted di- vision profits for the change in oil prices from the first Gulf War. In fact, the firm might want to enter financial contracts (e.g., futures, forwards, swaps, or options) to transfer this risk from the fibers division to external markets to reduce the risk im- posed on the division’s employees and hence the required compensating differentials in their compensation packages.20
Group Incentive Pay
In the basic principal-agent model, employees are motivated by being paid based on their own output. Many firms, however, base incentive pay on group performance— DuPont is an example. In one study, 78 percent of responding companies offered nonexecutive employees performance-related pay in addition to base pay, and 28 percent of firms provided stock options to nonexecutives.21 This group pay can take a variety of forms: Payoffs can be linked to the performance of the team, business unit, or the firm as a whole; and performance can be measured by stock prices, accounting earnings, or other more focused measures. (See Chapter 17 for a more extensive discussion of group performance measures.)
There are several reasons why firms might favor group incentive plans over indi- vidual plans:
• Individual performance generally is difficult to measure, while the perfor- mance of a group of employees often can be measured at reasonably low cost. For example, most firms’ cost accounting systems measure the performance of business units for control purposes. Hence, at little additional cost these mea- sures also can be used in administering compensation plans. However, further disaggregation—in the limit, providing a personalized measure of the perfor- mance of each employee—would be much more difficult and expensive.
ANALYZING MANAGERIAL DECISIONS: Granting Stock Options
Bobby’s Burgers is a large restaurant chain with
nearly 10,000 units worldwide. It is experiencing
incentive problems among its outlet managers. The
managers are not working very hard and are letting
quality deteriorate at their units. CEO, Bobby Jones,
is considering a stock plan where each unit
manager would be given 500 shares of stock in
Bobby’s Burgers. He reasons that making the
managers part owners of the company will motivate
better service.
1. Critically evaluate the proposed stock plan.
2. Discuss other ways that Bobby Jones might
motivate increased effort at the units.
20C. Smith (1995), “Corporate Risk Management: Theory and Practice,” Journal of Derivatives 2, 21–30. 21(2005), “Hewitt Study Shows Base Pay Increases Flat for 2006 With Variable Pay Plans Picking Up the
Slack” Business Wire (August 31).
484 Part 3 Designing Organizational Architecture
• Group pay encourages cooperation and teamwork, whereas some individual incentive plans (depending on design) motivate more self-centered actions.
• Group plans can motivate employees to monitor each other for poor perfor- mance. Mutual monitoring is beneficial because the specific knowledge about individual performance often is held by teammates.
• Group pay often is structured to help retain valued workers. Normally, it must be forfeited if the employee quits. Although employees must be compensated for this loss of flexibility, there can be important benefits of increased expected tenure; for example, it raises the expected payoffs of making certain firm-specific investments.
• Finally, if the demand for employees’ labor services by competitors is posi- tively correlated with their group’s success, then using group incentive pay can help adjust compensation automatically to reflect changes in employees’ opportunity costs. This can reduce contracting costs.22
Nonetheless, standard free-rider arguments provide a strong reason to question whether group plans provide effective incentives, particularly when the group is quite large. In DuPont’s fibers division, with its 20,000 employees, contributions of individual employees have little discernible effect on the overall bottom line (profits are an incredibly noisy measure of any individual employee’s output). Also individ- ual employees receive only a small fraction of the value each creates (it is shared with 19,999 other divisional employees as well as senior DuPont executives and the owners of the firm). Thus, profit-sharing plans would appear to produce limited in- centive effects. Yet this is not surprising. Should one really expect that paying a jan- itor on overall company performance would motivate that person to push the broom harder or to complain when other janitors shirk on their jobs?23 These arguments suggest that large-group incentive plans (like DuPont’s) impose risk on employees but produce limited benefits.
Although many economists find the free-rider arguments to be quite compelling, there are some offsetting considerations that potentially help explain the widespread popularity of group plans—despite the fact that free-riding is a problem. First, de- ferred compensation in the form of stock options or restricted stock makes it expen- sive for employees to leave and thus helps the firm retain employees. This will be es- pecially effective when labor market conditions and stock prices are positively correlated. In this case, their plans index the employees’ deferred compensation to their outside opportunities.24 Second, it might be beneficial to increase the awareness of employees about the stock-price performance and profitability of the company. By focusing on these measures, employees learn how managerial and employee ac- tions affect the bottom line. For instance, employees might be less likely to complain about a corporate restructuring when they see that it increases the firm’s stock price. Indeed, it probably takes little stock ownership to motivate most employees to mon- itor the stock price on a frequent basis. Hence, these benefits can be obtained while shifting little risk to the employees. Third, employees might be less likely to take actions that harm other members of a group with whom they identify closely. Thus,
22P. Oyer (2004), “Why Do Firms Use Incentives That Have No Incentive Effects,” Journal of Finance 59:4, 1619–1649.
23This example was suggested by K. J. Murphy. 24P. Oyer and S. Schaefer (2005), “Why Do Some Firms Give Options to All Employees? An Empirical
Examination of Alternative Theories,” Journal of Financial Economics 76, 49–133.
Chapter 15 Incentive Compensation 485
when the group receives incentive pay, employees might not want to harm team- mates by shirking on the job. In this case, attempting to avoid feelings like guilt or shame might motivate employees, even if they face limited direct financial conse- quences from shirking.25 Fourth, paying employees on stock-price performance and profits sends signals to employees about what is valued within the company. These signals serve to reinforce a performance-based corporate culture. To be most effec- tive, however, they must be complemented by other features of organizational architecture that provide more direct incentives.
Multitasking26
In the standard principal-agent model, effort is one-dimensional—the firm cares only about how hard the employee works. But most jobs involve a variety of tasks. For instance, employees on an assembly line can spend time increasing output, improving quality, performing preventative maintenance, or helping teammates. Similarly, professors at universities allocate their time among teaching, research, consulting, and administrative duties. Thus, managers usually have to be concerned not only with how hard employees work but also with how they allocate their time among assigned tasks; university officials are not indifferent to how professors allocate their time.
Motivating an employee to strike the appropriate balance among tasks is not easy. A complicating factor is that in some tasks, effort is more easily monitored and output more easily measured than in others. For instance, university officials can observe teaching ratings, whereas the quality of administrative service is harder to measure. Compensating employees based on what is measurable encourages them to exert effort on the compensated tasks but to shirk on the others. For example, paying professors based solely on teaching ratings would encourage effort on teaching at the expense of administrative service and research. Similarly, paying an assembler based on output would encourage the employee to produce more units but to ignore quality
25E. Kandel and E. Lazear (1992), “Peer Pressure and Partnership,” Journal of Political Economy 100, 801–817.
26This section draws on B. Holmstrom and P. Milgrom (1991), “Multitask Principal-Agent Analysis: Incentive
Contracts, Asset Ownership, and Job Design,” Journal of Law, Economics and Organization 7, 24–52.
M A N A G E R I A L A P P L I C AT I O N S
Red Envelopes, Gold Stars, and Mugs Many companies have formal recognition programs to praise employees who do an outstanding job on a special project
or just to say thank you. Cheryl Quinn at Xerox received a red envelope with a $100 dinner certificate for providing
some data for a senior manager’s special project that was outside of Quinn’s job description. Everyone in her
department saw the red envelope being delivered to Quinn and knew it signified that she was being recognized for her
performance. In fact there is a “recognition industry” that sells companies certificates, lapel pins, plaques, medallions,
mugs, candles, key chains, and feel-good toys like the “Squeezable Praise” (a pocket-sized foam toy that says “way to
glow”). Clearly, employees like praise and recognition. However, compensation consultants offer several warnings
about such recognition programs. Don’t hand out mugs to employees who have landed million-dollar contracts. It’s
demeaning. Don’t pit employees against each other to see who can get the most recognition mugs. And most important,
a plaque or certificate does not substitute for a good salary or benefits.
Source: R. Flanigan (2002), “Will Work for Praise,” Rochester Democrat and Chronicle (November 4), E1.
486 Part 3 Designing Organizational Architecture
or helping teammates. These multitask considerations suggest that firms often might want to avoid paying employees based solely on measurable outputs. The appendix to this chapter provides a more detailed analysis of these considerations.
Given enough time, managers are likely to obtain information about the overall performance of employees. For example, deans have the opportunity to observe the service of professors on committees; they hear comments on faculty research from colleagues; they talk to students about teaching quality. Incentives can be provided to employees by basing promotions, terminations, and periodic pay adjustments on this type of information. Indeed, universities rely heavily on these mechanisms to motivate faculty. Evaluating this information usually requires subjective judgments on the part of managers. To provide proper incentives to employees, managers must develop reputations of being impartial and objective. To be most effective, firms must establish performance measures and rewards that motivate managers to develop these reputations. The next chapter provides an expanded discussion of subjective performance evaluation.
Forms of Incentive Pay
The term incentive pay frequently evokes images of piece rates, commissions, and cash bonus plans, where employees are paid based on measurable output. This image is not surprising given that more than a quarter of the employees in the U.S. manufacturing sector receive at least part of their income through such incentive plans. Our discussion in this chapter suggests that mechanisms like tying promotions and salary adjustments to performance also are forms of incentive pay. Broadly speaking, any compensation contract (explicit or implicit) that rewards employees for good performance or pun- ishes employees for poor performance can be considered incentive pay. (Recall the Mary Kay Cosmetic Company’s innovative use of incentives discussed in Chapter 11.) Under this definition, all the following are forms of incentive compensation:27
• Piece rates and commissions
• Bonuses for good performance
• Prizes for winning contests (e.g., vacations)
• Salary revisions based on performance
• Promotions and titles for good performance
• Preferred office assignments for good performance
• Stock ownership and profit-sharing plans
• Firings and other penalties for poor performance
• Deferred compensation and unvested pensions that are forfeited on dismissal
It is important to emphasize that rewards do not have to be monetary. Rewards can consist of anything that employees value. For example, managers in some organizations have little flexibility in what they pay employees. Nonetheless, incentives can be pro- vided by rewarding more productive employees with desirable job assignments, better offices, preferred parking spaces, special honors, and trips to training sessions in attrac- tive locations.
27G. Baker, M. Jensen, and K. Murphy (1988), “Compensation and Incentives: Practice versus Theory,”
Journal of Finance 43, 593–616.
Chapter 15 Incentive Compensation 487
Incentive Compensation and Information Revelation
The basic principal-agent model assumes that the employer and employee have the same information at the time of initial contract negotiations. In some contract- ing situations, precontractual information is asymmetric.28 For example, prospec- tive employees generally know more about their likelihood of quitting over the next year than the prospective employer. Similarly, sales representatives are more likely to know about the sales potential of their territories than are higher-level managers.
Sometimes it is possible for the firm to induce employees to reveal their private in- formation by clever design of the compensation contract. Consider the example of Onex Copy Company. This company uses sales representatives throughout the coun- try to sell copy machines to customers. Each salesperson is assigned a specific territory. Some territories have greater sales potential than others. For simplicity, suppose that there are only two types of territories, good and bad. Good territories have the potential to generate $2 million in sales, while bad territories have the potential to generate only $1 million in sales. The sales representatives know the quality of their own territories. Central managers have insufficient information to distinguish between good and bad territories.
The firm would like to use information about whether specific territories are good or bad to evaluate the performance of the sales representatives. The company also wants accurate forecasts to plan production cycles. The company simply could ask the sales representatives to state the quality of their territories. But the sales repre- sentatives with good territories are likely to be less than completely truthful: If the firm thinks that a good territory is bad, the representative will look better when sales are high. (Alternatively, the salesperson can generate the expected poor sales with only limited effort.)
In this example, the firm can induce the salesperson to tell the truth by offering the following menu of contracts. Sales representatives who state that their territories are good receive compensation contracts that pay 2.6 percent of sales. Sales representa- tives who state that their territories are bad receive a flat wage of $50,000. Given this choice, it is in the interests of all salespeople to tell the truth: Those with bad territo- ries would prefer the $50,000 wage contract (2.6 percent of $1 million � $26,000), whereas those with good territories would prefer the contract that pays 2.6 percent of sales (for them, a $52,000 payout). The key to making the plan work is that the com- pensation for each type of employee is higher when the information is correctly re- ported than when it is not.
In this example, there are many potential compensation plans that would induce truth telling. The problem for the firm is to choose the most profitable contract. Onex is likely to want the compensation contract to provide strong performance in- centives, as well as to induce truth telling. Thus, it might choose to pay commis- sions to both types of employees but structure different commission rates to induce truth telling.
28In Chapter 10, we divided asymmetric information into two categories—precontractual and postcontractual.
Thus far, in this chapter, we have focused on postcontractual information problems (also called moral- hazard or agency problems). In this section, we discuss precontractual information problems (also called adverse-selection problems).
488 Part 3 Designing Organizational Architecture
Selection Effects of Incentive Contracts
Chapter 14 described how firms can use compensation, and in particular the mix of fringe benefits and pay, to attract a particular type of employee. The example given was the use of health, life, and dental insurance plans, which are valued more highly by employees with families than by single employees. By offering a compensation package rich in such fringe benefits and slightly lower pay, more married employees will be attracted to the firm. This section describes a similar selection mechanism in- herent in incentive compensation plans that can attract more productive workers to the firm.
The basic principal-agent model presented earlier in this chapter assumes that all agents are identical in terms of their marginal productivity [� in Equation (15.5)]. But employees generally have different marginal productivities. Firms that value more productive employees would like to attract these employees to their firms. In- centive contracts as in Equation (15.7) not only motivate employees like Erica to ex- pend more effort, but also can help attract high � employees to work at the firm. To see this, assume that employees know their own marginal productivities (their �’s), but the firm does not. For simplicity, further assume all employees have the same reservation utility, $1,100. While the firm does not know any single employee’s �, the firm can set a W 0* (fixed salary) and a �* (piece rate) to ensure that workers who apply for the job and stay with the firm have a minimum marginal productivity of � � �*. The resulting incentive contract, W 0* � �* � output, causes less productive employees (� � �*) to leave the firm.
Recall that Erica has marginal productivity of $100 per unit of effort and disutil- ity of effort, e2. Given the expected compensation contract of $1,000 � .2 � output, she chooses e* � 10 (see Figure 15.2). With e* � 10, Erica has expected compen- sation of $1,200 and expected utility of $1,100 ($1,200 � 102), which just equals her reservation utility. Suppose that Erica and Leo apply for this job. Leo, like Erica, also has reservation utility of $1,100, but Leo’s marginal productivity is only $90 per unit
M A N A G E R I A L A P P L I C AT I O N S
Pros and Cons of Stock Options to Motivate Executives Many firms, although not as many as in previous years, grant stock options to executives to help align the interests of
managers and shareholders. In the 1970s and 1980s, some executives were accused of being more interested in empire-
building to justify higher salaries and lavish expenses than in generating returns for shareholders. Granting options as
part of their compensation packages gave managers stronger incentives to maximize the share price. However, options
have prompted some executives to focus on the short-term performance of the shares rather than the long-term health
of the business. Missing its quarterly earnings target can lower the firm’s stock price and significantly reduce an
executive’s options pay off. Cutting back on research and development (R&D) expenses can raise short-run profits but
adversely affect long-run firm value. In fact some executives reduce R&D and advertising right before these options
vest and thus can be exercised. This boosts short-term profits to meet earnings targets and presumably reduces the
likelihood of a stock price decline before the executive cashes out her stock options.
This article illustrates the dictum “there is no magic bullet.” Although adding stock options to an executive’s
compensation package can control problems in some dimensions (options encourage executives to increase the share
price and thus the value of their options), options also can generate perverse incentives in other dimensions.
Source: (2014), “Share Options: The law of unintended consequences,” The Economist (February 8), www.economist.com/news/ finance-and-economics/21595985-when-bosses-take-short-view-law-unintended-consequences.
Chapter 15 Incentive Compensation 489
of effort. Once Leo learns of the incentive contract, he is better off doing something else than working for this firm. Leo’s expected compensation under the contract is $1,000 � .2 ($90e). Assuming Leo, like Erica, has the same cost of effort, e2, he will choose to exert 9 units of effort and thus expects to earn $1,162, yielding expected util- ity of $1,081 ($1,162 � 92).29 Leo’s expected utility given the incentive contract is less than his reservation utility. Leo thus will elect to work elsewhere, whereas Erica elects to stay with the firm. By offering greater pay-for-performance incentive contracts, firms can attract a more productive workforce.
Lazear studied workers who install auto windshields at a particular firm that changed from fixed salaries to piece rates.30 Productivity at this firm rose 35 percent while wages (salary plus incentive pay) increased 12 percent. One-third of the im- proved productivity arose because the less productive employees left the firm and were replaced by more talented employees. The Lazear study documents how incen- tive contracts can generate selection effects.
Does Incentive Pay Work? Throughout this chapter, we have argued that compensation plans motivate employ- ees. Although this argument is readily accepted by many people, it is not without con- troversy. Quality guru W. Edwards Deming went so far as to assert that “pay is not a motivator.” In the same spirit, psychologist Alfie Kohn, in a controversial article on the merits of incentive pay, states, “Bribes in the workplace simply can’t work.”31
Critics of incentive pay generally rely on two basic arguments. The first is that money does not motivate employees. As support for this view, it is pointed out that employees usually rank money relatively low when it comes to factors that make a job attractive. Factors such as the nature of work and quality of colleagues appear more important. The second, more prominent criticism is that it is difficult (if not impossible) to design an effective incentive compensation plan. Support for this ar- gument is provided by the many examples of flawed compensation plans that have produced unwanted behavior (e.g., the case of Merrill Lynch discussed in Chapter 2). Interestingly, these two lines of criticism are somewhat at odds with one another. If money did not motivate people, incentives plans would not produce the dysfunc- tional behavior that proponents of the second argument cite. In making a similar point, economist George Baker notes, “The problem is not that incentives can’t work but that they work all too well.”32
Certainly, it is easy to identify examples of compensation plans that have caused dysfunctional behavior among employees. We have done so throughout this book. Incentive plans also involve administrative costs, such as tracking output and ex- plaining the system to employees. The important question is not whether incentive plans entail costs—they certainly do. Rather, is it possible to design incentive plans where the benefits exceed the costs? Examples like the Lincoln Electric Company (discussed in Chapter 16) suggest that the answer is yes. Also, applying Economic
29For the technically inclined, Leo will maximize his expected utility, $1,000 � .2($90e) � e2. To find the level of effort (e*) that maximizes his expected utility, take the derivative of this function and set it to zero: 18 � 2e* � 0. Or, e* � 9.
30E. Lazear (2000), “Performance Pay and Productivity,” American Economic Review 90:5, 1346–1361. 31A. Kohn (1993), “Why Incentive Plans Cannot Work,” Harvard Business Review (September–October),
54–63. 32G. Baker (1993), “Rethinking Rewards,” Harvard Business Review (November–December), 44–45.
490 Part 3 Designing Organizational Architecture
Darwinism (see Chapter 1), the fact that incentive plans—commissions, piece rates, bonus plans, and stock options—have survived so long in a competitive marketplace suggests that the net benefits of incentive pay often are positive.
The scientific evidence overwhelmingly supports the proposition that agents re- spond to incentives.33 Prendergast describes a battery of tests from chicken farmers to professional athletes to CEOs that show incentives matter. But equally persuasive are studies of agents taking actions that benefit the agent at the cost of overall effi- ciency—agents gaming the system. But why is this surprising? The basic premise of agency theory is that employees act in their own self-interest. With incentive schemes, agents act to maximize their own self-interest, given the structure of the in- centive contract; sometimes this involves gaming the system. And in poorly designed incentive schemes, actions that benefit the agent can reduce firm value. Incentive compensation schemes are more likely to be value enhancing if they are designed to limit the agent’s gaming behavior. The evidence also points to significant selection effects from incentive contracts. More productive employees prefer higher pay-for- performance contracts because under these contracts more productive workers can earn more money.
When designing monetary incentives, one must also take account of the nonmon- etary incentives, one needs to consider the implicit incentives (moral and social) that people already face. Take the example of Israeli day-care centers that began charging parents $3 every time they picked-up their children later than the specified time. The number of late pickups more than doubled.34 The small monetary fine was not large enough to overcome the implicit incentives (the guilt of inconveniencing the day-care workers), and in fact, by paying the $3 fine now made it OK to be late. Most econo- mists would agree that as the fine for being late increased to say $50, fewer late pick- ups would occur.
The Power of Incentives—Evidence from Chinese Agriculture One especially interesting piece of evidence on the effectiveness of incentive pay comes from one of the largest
economic experiments in history—reforms in Chinese agriculture in the early 1980s. Between 1952 and 1978, the
Maoist period, Chinese agriculture revolved around the commune system. Under this system, employees were divided
into production teams. There were some attempts to tie pay to performance. However, these incentives were relatively
weak, and there was a tendency to base pay on family size, independent of effort. From 1980 to 1984, under the rule of
Deng Xiaoping, the commune system was gradually replaced by the “household-responsibility system.” Under this
system, each peasant family was given a long-term lease on a plot of land. The family had to deliver a quota of
agricultural products to the government each year, but it could keep any production in excess of the quota. This
additional output could be consumed by the family or sold to others.
Economic theory argues that the ownership of residual claims on output provides strong incentives. Thus, this theory
predicts higher productivity under the household-responsibility system than the commune system. Empirical studies
support this prediction. For instance, one study estimated that productivity in Chinese agriculture increased by nearly
50 percent over the period of the Dengist reforms.
Source: J. McMillan (1992), Games, Strategies, and Managers (Oxford University Press: New York), 96–98.
A C A D E M I C A P P L I C AT I O N S
33This material draws heavily on C. Prendergast (1999), “The Provision of Incentives in Firms,” Journal of Economic Literature (March), 7–63.
34http://freakonomics.com/2013/10/23/what-makes-people-do-what-they-do/
Chapter 15 Incentive Compensation 491
Although the evidence supports the view that incentives matter, for better or for worse, the evidence is mixed regarding other implications of the theory we described in this chapter. In particular, Table 15.2 predicts that when the level of risk, that is, beyond the employee’s control is low, we should observe high levels of incentive pay, holding everything else constant (the sensitivity of output to employee effort, the em- ployee’s risk aversion, and so forth). Unfortunately, research has yet to document con- vincingly this simple proposition that greater environmental uncertainty causes less in- centive pay to be used. A potential difficulty in examining this proposition involves issues we discussed in Chapter 12. If greater environmental uncertainty leads to more delegation of decision rights to the employee, then this greater delegation requires more (not less) incentive pay.35
Prendergast gives the example of a firm involved in two large construction pro- jects: one in Canada, where there is little environmental uncertainty because it has a long track record of similar Canadian projects, and a new project in Armenia, where the firm has no experience and the economic environment is highly uncer- tain. The manager of the Canadian project receives a salary with a small bonus, whereas the Armenian project manager’s pay is tied to project profitability. In Canada, the project manager is assigned few decision rights because central man- agement knows what should be done and can directly monitor the Canadian project manager. But central management has little specialized knowledge of the Armenian project and must delegate more decision rights to the Armenian manager. It is more expensive for headquarters to monitor the Armenian manager than the Canadian manager. To motivate the Armenian manager to exercise these additional decision rights to maximize firm value, headquarters structures the Armenian manager’s compensation plan to include more incentive pay. In this case, for risk-neutral man- agers, uncertainty and the amount of incentive pay are positively correlated. But, for risk-averse employees the correlation can be positive (if the delegation incentives
M A N A G E R I A L A P P L I C AT I O N S
Teachers Gaming Student Test Scores To improve public education, a number of school districts reward educators with cash bonuses if their school’s test
scores rise. However, such systems have spawned cheating among teachers to boost their ratings. The Atlanta school
district began paying teachers and principals bonuses if students’ standardized tests scores improved, and they did. A
State review into the improved test scores determined that some cheating occurred in more than half of Atlanta’s
elementary and middle schools starting in 2001 when standardized testing scores began. Thirty-five educators in the
Atlanta school district, including principals, teachers, and testing coordinators were indicted by the local authorities for
allegedly plotting to falsify students’ standardized tests. Twenty-three have plead guilty. At least 178 teachers and
principals, have said cheating may have been going on for years. Some administrators even held “erasing parties” to fix
the tests. One principal even wore gloves when she altered students’ tests to avoid leaving fingerprints. More than 80
educators confessed and many resigned.
Atlanta is not an isolated incident. Widespread teacher cheating has been uncovered in Kentucky in the late 1990s
and in Philadelphia in 2014. These examples demonstrate that poorly designed incentive plans can induce
dysfunctional behavior.
Source: K. Severson and A. Blinder (2014), “Test Scandal in Atlanta Brings More Guilty Pleas,” NY Times (January 14), www.nytimes.com/2014/01/07/education/test-scandal-in-atlanta-brings-more-guilty-pleas.html?_r=0.
35C. Prendergast (2002), “The Tenuous Trade-off between Risk and Incentives,” Journal of Political Economy (October), 1071–1102.
492 Part 3 Designing Organizational Architecture
ANALYZING MANAGERIAL DECISIONS: The Debate over CEO Compensation
The most visible and highly paid person in most
corporations is the chief executive officer (CEO).
CEO compensation is particularly important to
firms for three reasons. First, the compensation
package is likely to be important in attracting and
retaining good CEOs. Second, the form of the pay
contract is likely to help determine whether the
CEO focuses on value maximization or some other
objective. Third, employees throughout the organiza-
tion carefully follow their CEO’s pay. Important
morale problems can occur when employees think
that the CEO is overpaid. For instance, employees
complain bitterly when they are asked to take pay
cuts because the company is in trouble, yet at the
same time the CEO gets a big raise.
Controversy over CEO pay has increased sub-
stantially in recent years. One charge is that the
level of CEO pay is too high. CEO pay is so huge that people don’t believe they deserve it. It is easy
to point to many CEOs who report compensation in
the millions of dollars (reported compensation fig-
ures typically include salary and bonus payments,
as well as the expected value of stock option and re-
stricted stock grants). Consider the following two
examples. Investors were outraged when the giant
Swiss drug company Novartis gave its departing
chairman, Daniel Vasella, $78 million as part of a
non-compete contract, whereby Vasella would keep
collecting his annual salary so long as he didn’t go
work for a competitor. After this turned into a giant
PR disaster, Vasella and the board called the whole
thing off. In 2009, Hewlett-Packard laid off 6,400
workers but paid its CEO Mark Hurd $24.2 million.
In 1980, CEO compensation was 42 times that of
the average worker. In 2013, it was 331 times.
The second major criticism of CEO pay con-
cerns how CEOs are paid. Critics argue that CEOs
are agents of stockholders and that CEO pay should
be based heavily on stock-price performance. In
some celebrated cases CEO pay appears discon-
nected to CEO performance. For example, the CEO
of the health care provider McKesson not only earned $145 million in 2013 but also received an
employment agreement containing an eye-popping
$469 million severance payout should he be
terminated. The CEO of General Growth Proper- ties received compensation of $66.7 million even though the firm spent most of 2010 in bankruptcy.
From 1980, the increasing use of stock options
and restricted stock grants has boosted the sensitivity
of the average CEO’s wealth to firm performance.
However, the absolute sensitivity of CEO wealth to
performance remains small. Research indicates that
for a $1,000 change in firm value, the wealth of the
average CEO of a large public corporation changes
by under $10 (depending on the year and estimation
method). Some argue this relation (which is equiva-
lent to the CEO owning less than 1 percent of the
common stock) is too small and that most compa-
nies would be better off if they increased incentive
pay for CEOs. Some support for this view seems to
come from studies that document an increase in
stock price when companies announce that they are
increasing incentive pay for CEOs.
1. Do you think the fact that most American
CEOs are paid so much more than rank-and-
file employees suggests CEOs are overpaid?
Explain.
2. Japanese CEOs generally receive much lower
levels of compensation than CEOs in the
United States. Does this imply that U.S. CEOs
are overpaid?
3. Is it obvious that $10 per thousand is too low
of an incentive pay for CEOs? Explain.
4. Does the observation that the stock price
increases when firms increase incentive pay for
CEOs suggest that most CEOs do not receive
enough incentive compensation? Explain.
5. Are there any reasons why overpaying CEOs
might be in the shareholders’ interest
(i.e., maximize shareholder value)?
SOURCE: M. Herper (2013), “Novartis' Exorbitant Pay Package For Former CEO Was More Ridiculous Than It Looked,” Forbes (Feb- ruary 19); N. Hindman (2011), “The 10 Highest-Paid CEOs Who Laid Off The Most Workers,” Huffington Post (September 1); www.aflcio.org/Corporate-Watch/Paywatch-2014; K. Murphy (2013), “Executive Compensation: Where We Are, and How We Got There,” in G. Constantinides, M. Harris and R. Stulz (Eds.), Handbook of the Economics of Finance Vol 2, Part A, (Elsevier: Amsterdam), 211–356; A. Lomax (2011) “CEO Pay Defies the Laws of Gravity,” The Motley Fool (December 16).
Chapter 15 Incentive Compensation 493
dominate the risk-aversion costs) or negative (if the risk-aversion costs dominate the delegation incentives).
While the empirical evidence does not support the simple proposition in Table 15.2 that risk and incentives should be negatively correlated, a potential problem is that the research has not held other things constant. For example, uncertainty af- fects both the risk imposed on the agent and also the delegation of decision rights. One of the benefits of decentralization is more effective use of local knowledge. In environments with greater uncertainty, local managers likely have better informa- tion than more senior managers. Thus, as described by Prendergast, one would ex- pect more delegation of decision rights as uncertainty increases. This discussion again highlights the importance of Figure 11.1. The firm’s organizational architec- ture varies depending on the strategies chosen. All three legs of the stool are de- signed to complement each other and to support the firm’s strategy. Simple empir- ical tests that just examine one leg at a time (such as how compensation varies with risk) must control for how the other legs are also adjusted (such as how the as- signment of decision rights varies with risk).
Summary Incentive problems exist because of conflicts of interest between employers and em- ployees. These problems are easily resolved when actions are costlessly observable. Firms can identify the most efficient actions by employees and pay employees only if these actions are taken. In most situations employee actions are not observable at low cost. Here, firms can motivate employees through incentive compensation.
In a competitive labor market, employees must be compensated for undertaking actions they find undesirable—there are compensating differentials. Thus, it is not sensible to have employees work as hard as possible. In eliciting particular actions, there is a trade-off between the benefits of the action for the firm and the personal costs to the employees.
Incentive problems arise because most of the costs of exerting effort are borne by employees, whereas most of the gains go to their employers. Sometimes, there is a simple way to resolve this incentive problem even when the actions of employees are unobservable. The solution is to sell each employee the rights to his or her total out- put. By selling employees their output, both the benefits and costs of exerting effort are internalized by employees and thus employees will make more productive choices. We observe this solution being approximated in private firms as well as in franchising. There are at least three important factors that limit the use of ownership in solving incentive problems: wealth constraints, team production, and costs of in- efficient risk bearing.
Risk-averse individuals do not like to bear financial risks; they prefer income flows with less volatility. Risk-averse individuals can benefit from sharing risks because it lowers the volatility of the individual cash flows. People often vary in their attitudes to- ward risk. For instance, some people are more willing to tolerate financial risks than others. An efficient allocation of risk takes these differences in preferences into ac- count. If one party is risk-neutral whereas another party is risk-averse, it is better to have the risk-neutral party bear all the risk and the other party to receive a fixed payment.
Stockholders of firms often hold diversified portfolios; this is a powerful method for managing firm-specific risks. Employees, in contrast, have much of their human capital invested in a single firm and hence have fewer opportunities to manage risk through diversification. Thus, from a risk-sharing standpoint, it is better to pay employees more through fixed salaries and to let the risk of random income flows be
494 Part 3 Designing Organizational Architecture
borne more by the shareholders. Yet fixed salaries provide limited incentives for employees to exert effort: Therefore, there is a trade-off between optimal risk shar- ing and optimal incentives.
Economic analysis of incentive compensation begins with the basic principal- agent model. This model presents a relatively simple characterization of the con- tracting process. However, it illustrates the trade-offs between risk sharing and in- centives and provides a number of useful insights for designing better compensation plans. In particular, the model suggests that firms should pay more performance- based pay when (1) the sensitivity of the value of output to additional effort by the employee is higher, (2) the employee is less risk-averse, (3) the level of risk that is beyond the employee’s control is lower, (4) the employee response to increased in- centives in terms of exerting additional effort is more pronounced, and (5) employee output is more easily measured.
According to the informativeness principle, it is useful to include all indicators that provide additional information about employee effort into the compensation contract—provided that these indicators are available at low cost. Including these in- dicators in the contract reduces the randomness of payouts and thus the costs of in- efficient risk bearing. One important source of information about an employee’s ef- fort is the output of coworkers performing similar tasks. The informativeness principle suggests that it is useful to employ relative performance evaluation. In Chapter 16, however, we discuss several factors that can limit the desirability of relative performance evaluations.
In the basic principal-agent model, employees are motivated by basing compen- sation on their own output. But many firms base incentive pay on group performance. Common reasons offered for group incentive pay are that group performance can be less expensive to monitor than individual performance, group performance empha- sizes teamwork, and group plans motivate employees to monitor one another’s per- formance. Standard free-rider arguments provide a strong reason to question whether group plans provide effective incentives—particularly when the group is large. At least three factors might help explain the widespread popularity of these plans, even though free-riding is a potential problem. First, it can be beneficial to increase em- ployee awareness of stock-price performance and profitability (assuming employees can be motivated to monitor these measures by relatively modest plans that do not im- pose much risk on employees). Second, employees might feel guilty from shirking and imposing costs on teammates who are compensated on group performance. These feelings might motivate employees, even if the direct financial consequences are small. Third, paying employees on firm performance sends a strong signal to em- ployees about what is valued within the company. To be most effective, however, these signals must be reinforced by other parts of the organizational architecture that provide more direct incentives.
Most jobs involve a variety of tasks. Motivating an employee to strike the appro- priate balance among tasks is not easy. A complicating factor is that some tasks are more easily measured than others. Compensating the employee based on what is measurable will encourage the employee to exert more effort on the compensated tasks but shirk on other tasks. These multitasking considerations suggest that firms often want to avoid paying employees based solely on measurable outputs. Given enough time, managers are likely to obtain information about the overall perfor- mance of employees. Incentives can be provided by basing promotions, termina- tions, and periodic pay adjustments on this information. Often, this information is not easily quantifiable but is based on the subjective opinions of supervisors.
Chapter 15 Incentive Compensation 495
The term incentive pay conjures up images of piece rates, commissions, and cash bonus plans, where the employee is paid based on measurable output. Broadly speaking, however, any compensation contract (explicit or implicit) that rewards employees for good performance or punishes employees for poor performance can be considered incentive pay. Rewards do not have to be monetary. Rather, rewards consist of anything that employees value.
The basic principal-agent model assumes employers and employees have the same information at the time of initial contract negotiations. In many contracting sit- uations precontractual information is asymmetric. Sometimes it is possible for the firm to induce employees to reveal their private information by clever design of the compensation contract. For such a plan to work, the payoffs to employees must be higher when they are honest than when they misrepresent information.
Throughout this chapter, we have argued that compensation plans motivate em- ployees. Although this argument is accepted by many, it is not without controversy. Critics of incentive pay rely on two basic arguments. The first is that money does not motivate people. The second, more prominent criticism is that it is difficult (if not im- possible) to design an effective incentive compensation plan. The first argument seems inconsistent with the many examples where monetary incentives have dramatically affected employee behavior. The second argument is correct: Developing an appro- priate incentive plan rarely is easy. The important question is whether plans can be de- signed where the benefits exceed the costs. Examples such as Lincoln Electric suggest it can be done. Our intent is to provide insights into how managers might design value-maximizing contracts.
G. Baker, M. Jensen, and K. Murphy (1988), “Compensation and Incentives: Practice versus
Theory,” Journal of Finance 43, 593–616.
J. McMillan (1992), Games, Strategies, and Managers (Oxford University Press: New York), 91–129.
P. Milgrom and J. Roberts (1992), Economics, Organization, and Management (Prentice Hall: Englewood Cliffs), 206–247.
K. Murphy (2013), “Executive Compensation: Where We Are, and How We Got There,” in G. Con-
stantinides, M. Harris and R. Stulz (Eds.), Handbook of the Economics of Finance Vol 2, Part A, (Elsevier: Amsterdam) 211–356.
15–1. You work for a compensation consulting firm. You are designing a pay package for the CEO of a major corporation. The board has asked you to choose the parameters a, b, and c, in the following pay contract:
Pay � a � b [(company stock return) � c (industry stock return)]
Discuss the key factors that will influence your recommendation for each of these three
parameters.
15–2. You are a sales manager at the XYZ Corporation. You want to hire a new sales representa- tive. You plan to make an offer to Sally Gomez. You can pay Sally a fixed salary of $20,000
per year or a 10 percent sales commission plus � (a fixed component in the compensation formula). She has a competing offer at another company for $20,000. You anticipate you
can hire her if you meet the $20,000 fixed salary offer.
Sally’s sales will be either high or low depending on whether she gets a corporate ac-
count. If she gets the account, sales will be $100,000. If she does not, sales will be $10,000.
The probability of getting the account is .7. This probability is beyond Sally’s control.
Sally’s utility function can be represented by
u (compensation) � (compensation)1�2 (1)
Self-Evaluation Problems
Suggested Readings
496 Part 3 Designing Organizational Architecture
She seeks to maximize expected utility. Expected utilities under the two plans are
Fixed salary: u � (20,000)1�2 (2)
10 percent plan: u � .7(� � 10,000)1�2 � .3(� � $1,000)1�2 (3)
a. Sketch the graph of the function u (x) � (x)1�2. b. Is Sally’s utility function convex or concave? Is she risk-loving or risk-averse? c. What � makes Sally indifferent between the two plans? d. As the sales manager, which plan do you select? Give an explanation that shows why
this plan is optimal.
Solutions to Self-Evaluation Problems 15–1. Structuring Compensation
The optimal choice of c increases with the covariance of industry and company stock re- turns and decreases with the variance of industry stock returns. Industry stock returns are
included in the pay package to produce a more informative measure of the ability/effort of
the CEO. The information in these returns increases with the covariance between the two
returns and decreases with the variance of industry returns.
The optimal choice of b depends on the trade-off between optimal risk sharing and in- centives. It is optimal to choose a higher level of b when (1) the CEO’s stock return is sensi- tive to his effort, (2) the CEO is not very risk-averse, (3) the level of risk that is beyond the
CEO’s control is low, and (4) the CEO’s response to increased incentives is high (the CEO
exerts a lot more effort).
The optimal choice of a depends on the “reservation utility” of the CEO (which in turn depends on his demand in the outside labor market). It must be chosen so that the overall
pay package is sufficient to attract and retain the CEO.
15–2. Expected Utility and Structuring Compensation
a.
b. Concave, risk averse. c. The $20,000 for certain gives a utility of about 141. You can answer this question by
setting expected utility equal to 141 and solve by iteration (e.g., in Excel). The answer
is around 13,000.
d. The fixed salary. Neither plan affects the effort of the employee. Thus the manager wants to choose the plan that allows him to hire Sally at the lowest expected compensa-
tion. Since she is risk-averse the fixed plan is better. You must pay expected compensa-
tion of $20,300 to hire Sally.
15–1. Evaluate the statement: “Investment banking is a demanding profession; investment banks want their employees to work as hard as possible.”
15–2. Two employees are assigned to work overseas for a two-year period. One person sells his house in the United States, whereas the other leases it for two years to another family.
Which house do you think will be in better condition after the two years? Explain.
Review Questions
Chapter 15 Incentive Compensation 497
15–3. Explain why an investor is usually better off if she holds a diversified portfolio rather than investing all her resources in the stock of one company.
15–4. Discuss trade-offs between efficient risk bearing and incentives in compensation plans.
15–5. Some companies reward salespeople based on their performance relative to other salespeo- ple in the company. Why would a company want to do this?
15–6. Evaluate the statement: “Profit-sharing plans are good; they encourage teamwork.”
15–7. Some school districts have compensated teachers based on the performance of students on standardized tests. Do you think this is a good idea? Explain.
15–8. Evaluate the following statement: “John is paid a straight salary with no bonus pay. Obviously, he has no incentives to do a good job.”
15–9. Mrs. Fields’ Cookie Company is a very successful company out of Salt Lake City, Utah. The company sells freshly baked cookies to customers in shopping malls. The company
has expanded and opened outlets in other cities such as San Francisco. Debbie Fields has
been on the cover of several business magazines. The articles stress that Mrs. Fields
works very long hours and is often at the stores monitoring the quality of the product and
making sure the cookies are produced with “tender loving care.” The Fields have earned
millions of dollars from this business. In 1986, they were planning to open new outlets
throughout the country. They had a policy that they would not franchise units. To quote
Mrs. Fields, “We do not want to turn into just another fast-food franchise company. Our
success is based on high-quality products produced with great care and love. We do not
want to lose this quality by expanding through franchises. Rather, we prefer to maintain
ownership of all units to ensure continued good service and quality.” Evaluate the Fields’
franchising policy.
15–10. The Roman Empire taxed many faraway provinces. Rome would auction the rights to tax collection to the highest bidder. The winning bidder was given the right to set the tax rate
for the province and the right to collect (and keep) the taxes. In turn, the winner would pay
the bid amount to the Roman government. Assume (1) that the Roman Senate is interested
in maximizing the present value of all future revenues to Rome from auctioning off the tax
rights, and (2) that the auction for the rights to each province is conducted annually.
a. Give two reasons why Rome would auction off the rights to tax collection rather than simply send a Roman soldier to collect the taxes.
b. Discuss two problems this system might generate for the Senate.
15–11. There has been an increased emphasis on compensating employees through incentive pay. High incentive pay, however, is not likely to be productive in all settings. Discuss the fac-
tors that are likely to favor paying high incentive pay to employees.
15–12. In 1995, Philip Morris Company ratified a new labor pact that gave employees stock in lieu of pay increases. The agreement covered 7,800 employees, with each employee being
given 94 shares (1994 value of about $60 per share). Employees cannot sell the stock for at
least a year and forfeit the stock if they quit or are fired before the year expires.
BusinessWeek argued that the “deal was good for Philip Morris” because the employees’ base pay and fringe benefits did not rise. Also “current shareholders’ shares won’t be
diluted, since employees probably will get less than 500,000 shares out of 850 million
outstanding.”36 Discuss the pros and cons of this policy compared to a policy of simply
giving a cash bonus to employees of a similar dollar value.
15–13. Two successful firms are observed with quite different compensation plans for their sales- people. One firm pays its salespeople on a commission basis, whereas the other firm pays
its salespeople fixed salaries. Do you think that one of the two companies is making a
mistake? Explain.
15–14. Susan Jones is a salesperson at Radex Co. Her utility function can be represented by U � C 2, where C is her compensation.
36A. Bernstein (1995), “At Philip Morris, Blue Chips for Blue Collars,” BusinessWeek (March 27), 38.
498 Part 3 Designing Organizational Architecture
a. The company is considering paying her a sales commission rather than a straight salary. The sales manager, however, is concerned that he will have to pay her a
compensating differential for imposing risk on her, that is, beyond her control (sales at
Radex are heavily dependent on macroeconomic factors and central company
policies). Is the sales manager’s concern about paying Susan higher compensation
justified? Explain.
b. Is this example representative of the typical worker in most companies? Explain.
15–15. Top executives of European firms are typically paid substantially less than the top execu- tives of American firms. They are also paid differently. For example, stock options are
much more common among American than European executives. Do these differences
imply (1) that American executives are overpaid, and (2) that the form of the compensation
in either America or Europe is suboptimal? Explain.
15–16. Prior to 2004, American accounting rules did not require firms to expense stock options on their accounting statements. Thus, firms were able to grant executive stock options without
impacting “bottom-line performance.” Correspondingly, some people argued that the pri-
mary reason firms paid executives in the form of stock options was that they were free. Do
you agree (1) that stock options were free, and (2) that this is the primary reason for pay-
ing executives in options? Explain.
15–17. How does the concept of a risk premium in incentive compensation relate to the concept of a compensating differential in compensation policy?
15–18. Consider two successful sales companies. One company pays its salespeople a high com- mission, whereas the other pays its salespeople a straight salary. Assume that both compa-
nies are paying their salespeople in an optimal manner. Explain potential differences in the
firms that might help to explain the difference in pay policy.
15–19. Toledo Chicken is a large chicken processor that raises, processes, and packs both fresh and frozen chicken parts. The firm has five plants located around the United States. Fac-
tory employees have been paid a fixed salary, but recently Toledo switched to a piece-rate
pay system. What affect, if any, might you expect this change in compensation system to
have on Toledo’s productivity and total wages paid to factory employees? And discuss
what might be contributing to the change in productivity. In other words, what are the
sources of the productivity change?
This appendix provides a more detailed example of the multitask principal-agent model. It also uses this framework to analyze the corporate practice of telecommuting— employees working out of their homes and communicating with the central office via fax, computer, or telephone. This application illustrates how principal-agent theory can provide insights into specific managerial policy decisions.
Multitask Model Adel el Gazzar is a production employee at the Bijar Dye Company. He works 10 hours per day. His job consists of two tasks, assembling parts and checking the quality of his output. He is paid a piece rate for each part that he assembles. He also receives a bonus, that is, based on the quality of his output. Denote t1 and t2 as the hours per day he devotes to producing output and checking quality, respectively. Adel’s incentives are high enough so that he will not shirk: He works the full 10 hours. Therefore, t2 � (10 � t1).
Appendix: Multitasking Theory37
37This appendix requires elementary knowledge of calculus. This appendix draws on Milgrom and Holmstrom
(1991).
Chapter 15 Incentive Compensation 499
Suppose that Adel’s compensation translates into the following relation between compensation and the time allocated to each activity:
Compensation � �1(6t1 1�2) � �2t2 (15.9)
� �1(6t1 1�2) � �2(10 � t1)
where the �’s are the weights that the compensation plan places on quantity and qual- ity (the incentive coefficients).38 Adel’s objective is to maximize his compensation. He chooses t1 to meet the following first-order condition:
�1(3t1�1�2) � �2 (15.10)
This condition has a straightforward interpretation. The left-hand term is the marginal benefit for allocating time to producing higher quantity, whereas the right-hand term is the marginal benefit for allocating time to producing higher quality. At an interior solution, these marginal returns must be equal. If the marginal benefits are not equal, Adel is better off devoting more time to the activity with the higher value and less time to the activity with the lower value. Figure 15.4 provides an illustration. When t1 is small, the returns for devoting extra time to quantity are high relative to the returns from allocating time to quality. Here, it makes sense to increase the time devoted to quantity and correspondingly reduce the time spent on quality. As Adel continues to increase the amount of time he spends on quantity, the marginal benefit declines.39 At the optimum t1*, the marginal returns are equal. Beyond t1*, the marginal returns from allocating time to quantity are less than for allocating time to quality.
If Adel’s supervisor chooses �1 and �2 so that the marginal return for one of the activities is always higher over the relevant range, 0 � t1 � 10, Adel will devote all 10 hours to the activity with the higher marginal return (there is a corner solution).
Solving Equation (15.10) for t1 yields
t1 � 9(�1��2)2 (15.11)
MB quality
t1 10
MB quantity: a1(3t1 –1/2)
a2
$
t1*
Hours devoted to quantity
Figure 15.4 Optimal Allocation of Effort
In this example, Adel must allocate his time between two activities, producing quantity and checking its quality. The number of hours devoted to quantity is t1. Since he puts in 10-hour workdays, he devotes t2 � (10 � t1*) hours to quality. This figure illustrates the case where there is an interior optimum. At this optimum, the marginal benefit MB from allocating additional time to either activity is the same. Adel spends t1* hours on quantity and (10 � t1*) hours on quality. But if the marginal benefits for quantity are higher than the marginal benefits from quality over the relevant range (0 � t1 � 10), Adel allocates all his time to producing output—there is a corner solution.
38The terms in this equation are chosen to simplify the calculations and yield reasonable values for the time
allocated to the two activities. Our basic results, however, are quite general and are not specialized to this
particular example. 39Technical note: For simplicity, we assume that time devoted to producing quantity is more strenuous than
that devoted to quality. Thus, with more time devoted to quantity, he becomes tired and less productive.
We have assumed that the marginal benefit from allocating time to quality is constant. This assumption is
not necessary.
500 Part 3 Designing Organizational Architecture
This equation shows that when �1 � �2, Adel will spend nine hours producing out- put and one hour checking its quality. Observing how t1 and t2 change with changes in the �’s provides two important insights:
• A manager can motivate an employee to devote more time to a task in two ways: First, the manager can increase the incentive coefficient for that task. Second, the manager can reduce the incentive coefficient for the alternative task. In our example, Adel will devote more time to quantity if either �1 is in- creased or �2 is decreased. Increasing �1 increases the direct return from in- vesting in quantity, while decreasing �2 reduces the opportunity cost (the com- pensation, i.e., lost from not investing in quality).
• If an incentive coefficient for a given task is sufficiently small, relative to the other incentive coefficient, an employee will devote no time to the task. In our example, if (�1��2)2 � 1.12, Adel will devote no time to quality (1.12 � 9 � 10 hours). This result indicates that if a manager wants an employee to devote time to multiple tasks, the manager must be careful to provide balanced incentives. Setting too strong an incentive for one task can undermine effort on other tasks.
An Application: Telecommuting Recently, there has been an increase in the use of telecommuting by large firms— working out of an office in the employee’s own home. The asserted benefits of this practice are (1) companies can reduce office expense—it can be less expensive to re- imburse an employee for a home office than to provide office space in an urban cen- ter, (2) employees avoid wasteful commutes to work, (3) firms can hire higher-qual- ity employees at lower wages by offering them the flexibility to work out of their homes (for instance, employees can balance child care and career demands more easily), and (4) employees can be closer to customers (e.g., salespeople frequently have homes in their sales territories).
One potential drawback with telecommuting is the lost synergy that results from having employees work at separate locations. For instance, there is likely to be less information sharing, team production, and so on. While computer technologies (such as e-mail) reduce these concerns, they frequently are still important and limit the vi- ability of telecommuting in many occupations. For instance, it would simply be in- feasible for a dental assistant to telecommute. Another is the reduced ability to share specific equipment when individuals work from different locations. Our focus is on a third potential concern with telecommuting—the problem of motivating employ- ees to exert effort on their jobs.
In analyzing telecommuting, it is useful to envision the employee being at home and choosing how to allocate time between two activities, home and work. The in- centive coefficient for home activities (�1) is the personal benefit the employee ob- tains from spending extra time playing with children, watching television, working in the garden, and so on. The incentive coefficient for working on company activities (�2) depends on the compensation plan.
Viewed in this context, the multitask model has at least two important points relating to telecommuting. First, it usually is important to provide incentive compensation to telecommuters.40 Without sufficient incentives, employees tend to shirk and devote too much of their time to home activities rather than work. Second,
40As discussed in the text, this incentive pay need not take the form of a commission or a piece rate. Rather, it
can be a bonus plan, a promotion based on performance, and so on.
Chapter 15 Incentive Compensation 501
the most viable jobs for telecommuting are those where output is easily measured, and thus incentive compensation can be used most readily. For instance, sales jobs often are good candidates for telecommuting, since incentives can be provided by sales commissions. (Synergies from having salespeople work out of a central location also are likely to be relatively low.) If it is difficult to measure employee output, it can be better to require the employee to come to work at a central location. This require- ment has two effects. First, it is easier to monitor the employee’s efforts. Second, it is equivalent to reducing the incentive coefficient on home activities to zero (the em- ployee is unable to devote time to home activities and thus cannot gain from these ac- tivities). Since there are fewer activities that compete for their time, employees spend more time on work-related activities.
M A N A G E R I A L A P P L I C AT I O N S
Some Costs and Benefits of Telecommuting Cisco Systems, the computer-networking company, claims that telecommuters improve their productivity 25 percent
and save the company $1 million of overhead. Another company reported annual savings of $7,400 per telecommuting
employee. The Federal Government has promoted telecommuting as a way to reduce energy consumption, traffic, and
pollution. In 2004, Congress passed a bill that encouraged federal agencies to provide telecommuting options to all
eligible employees. In 2007, over 110,000 federal employees were telecommuting. Many private companies have also
begun using telecommuting. However, not all employers enthusiastically endorse telecommuting. One consultant
estimates that 20 percent of the programs fail—causes include resistant managers, isolated employees, and insufficient
opportunities for teamwork. Telecommuters have fewer opportunities to talk shop. Informal communications are
reduced. Companies schedule meetings, informal lunches, and other social interactions that used to happen
automatically. Other companies require telecommuters to spend at least a day or two at the office.
Source: A. Tergesen (1998), “Making Stay-at-Homes Feel Welcome,” BusinessWeek (October 12), 155–156; and J. Greer, T. Buttross, G. Schmelzle (2002), “Using Telecommuting to Improve the Bottom Line,” Strategic Finance (April), 46–50; and United States Office of Personnel Management (2007), “Status of Telework in the Federal Government.”
ANALYZING MANAGERIAL DECISIONS: Insurance Distribution Systems
Life insurance agents focus on selling policies. The
company expects little follow-up in terms of pro-
viding ongoing customer service. In contrast, auto
insurance agents often are expected to provide on-
going customer assistance after a policy is sold (an-
swering questions about the policy, providing assis-
tance in filing claims, and so on).
Some insurance companies use independent
agents to sell their policies. These agents are paid
solely on commission and are often allowed to
sell the products of other companies (the agent
presents the customer with a choice of plans
across multiple companies). Other insurance com-
panies hire their own agents. These employees are
restricted from selling other companies’ products
and are sometimes paid a salary in addition to any
commission they might receive.
1. Which type of insurance company, life or auto,
is more likely to use the in-house agent? Ex-
plain. (Be sure to discuss why the in-house
agent faces product restrictions and is not al-
ways paid on a pure commission basis.)
2. Some auto insurance companies separate the
tasks of selling and customer service and as-
sign them to different people. Why do you
think they do this?
chapter
16 C H A P T E R O U T L I N E
Setting Performance Benchmarks
Time and Motion Studies Past Performance and the Ratchet Effect
Measurement Costs Opportunism
Gaming Horizon Problem
Relative Performance Evaluation
Within-Firm Performance Across-Firm Performance
Subjective Performance Evaluation
Multitasking and Unbalanced Effort Subjective Evaluation Methods Problems with Subjective Performance Evaluations
Combining Objective and Subjective Performance Measures Team Performance
Team Production Evaluating Teams
Government Regulation of Labor Markets Summary Appendix: Optimal Weights in a Relative Performance Contract
L incoln Electric Company was founded in 1895 to manufacture electric motors and generators.1 In the early part of the 20th century, the firm became the premier supplier of electric arc welding machines, welding disposables (electrodes), and cutting
products. In 2007, Lincoln manufactured welding and cutting supplies and industrial electric motors in 30 plants across 18 countries. Prior to expanding manufacturing operations outside the United States in the 1980s, Lincoln Electric had an almost unbroken string of profitable years and often was cited as a model of productivity gains and cost savings.
Lincoln Electric’s strategy involves building quality products at a cost lower than that of its competitors and passing these savings to customers by continuously lowering prices. Lincoln has been able to implement this strategy, in part, through an employee incentive system that fosters labor productivity increases arising from a pay-for-performance compensation plan. For production employees, wages are based entirely on piecework. In addition, they receive a year-end bonus which averages approximately 100 percent of regular compensation.
Individual Performance Evaluation
L E A R N I N G O B J E C T I V E S
1. Describe how firms set performance benchmarks. 2. Define and apply the ratchet effect. 3. Explain why the amount spent on performance measure and the intensity of
incentives in compensation plans tend to be positively correlated.
4. List examples of how employees can game performance measurement. 5. Define and apply the horizon problem. 6. Explain the benefits and costs of relative performance evaluation. 7. Discuss the advantages and disadvantages of subjective performance measures
relative to objective measures.
8. Explain why some firms employ forced ratings systems and the kinds of problems that can arise with these systems.
9. Explain why many firms combine objective and subjective performance measures. 10. Describe key issues that arise in the evaluation of teams.
1Details of this example are from N. Fast and N. Berg (1975), “The Lincoln Electric Company,”
Harvard Business School Case 376–028; C. Bartlett (1998), “Lincoln Electric: Venturing
Abroad,” Harvard Business School Case 9-398–095; and Lincoln Electric’s financial reports; and
“Employees’ Handbook” (2011)
A key element of Lincoln’s organizational architecture, and the topic of this chap- ter, is its performance-evaluation system. There are two components of Lincoln’s performance evaluation: Pieces produced and merit rating. The first component is an objective, readily quantifiable performance measure for each production em- ployee—the number of good units produced. The employee’s wage is equal to a piece rate times the number of good units produced. (Employees are not paid for de- fective units.) The piece rates—set by the time study department—allow employees producing at a standard rate to earn a wage comparable to those for similar jobs in the local labor market. However, by working hard—in some cases even through meal and coffee breaks—employees can double and sometimes triple their pay. Moreover, Lincoln’s policies prohibit piece rate changes simply because an employee is mak- ing “too much” money. Finally, any employee who has been at Lincoln for at least two years is guaranteed employment for at least 75 percent of the standard 40-hour week.
The second component of Lincoln’s evaluation system is the employee’s merit rating. These ratings are used to determine the employee’s share of the annual bonus pool. Although there is substantial annual variation, the size of the bonus pool aver- ages about 30–40 percent of total wages and is typically about twice Lincoln’s net in- come after taxes. Each employee’s merit evaluation is based on employee depend- ability, quality, output, ideas, and cooperation—all of which are assessed primarily by the employee’s immediate supervisor.
Lincoln was primarily a U.S. company until the mid-1980s, but a U.S. recession and competition from abroad led Lincoln to embark on a global expansion. It added manufacturing plants in 11 new countries, and attempted to export its unique man- agement philosophy to these new plants. However, its efforts to replicate its highly productive system abroad failed. Lincoln took on large amounts of debt to finance its foreign expansion, mostly in Europe. In 1992, losses from the company’s European operations were so steep that Lincoln was near default on its loans and was unable to pay its employees their year-end bonus. Several factors doomed Lincoln’s interna-
M A N A G E R I A L A P P L I C AT I O N S
U.S. Health Care System Adopts Pay-for-Performance The adoption of performance-based payment incentives is one of the most important changes in the U.S. health care
system. Many large health insurers, including health maintenance organizations (HMOs), now employ pay-for-
performance as a key mechanism to motivate their health care providers. Popular performance measures include rates
of screening for various diseases (e.g., percent of diabetic patients undergoing annual testing) and immunization,
patient satisfaction, and compliance rates for appropriate use of medications. One study examined 24 programs that
varied in size from 50,000 to 11 million enrollees and covered hospitals, clinics, primary care physicians, and
specialists such as cardiologists and general surgeons. It found that nearly all programs have increased the number of
measures that factor into the calculation of performance bonuses. Payers have increased both the size of the financial
incentives and the number of measures on which they are based. After adopting more pay-for-performance, some
improvement was documented in various clinical areas such as diabetes care, cancer screening, and inpatient cardiac
care. However, pay-for-performance still remains a small portion of total payments to providers.
Source: M. Rosenthal, B. Landon, K. Howitt, H. Song, and A. Epstein (2007), “Climbing Up the Pay-for-Performance Learning
Curve: Where Are the Early Adopters Now?” Health Affairs (November/December), 1674–1683; and G. Young, D. Conrad, A. Fallat (2007), “Practical Issues in the Design and Implementation of Pay-for-Quality Programs,” Journal of Healthcare Management (January/February), 10–20.
Chapter 16 Individual Performance Evaluation 503
504 Part 3 Designing Organizational Architecture
tional expansion including a recession in Europe, lack of familiarity with Europe’s labor culture and regulation, and limited international expertise among its senior managers. Lincoln was forced to restructure its European operations. It wrote off most of its European facilities, increased U.S. production and sales, and hired top managers and nominated board members with substantial international experience. Finally, Lincoln managed to resume paying bonuses and to regain the trust of its em- ployees.
Three important observations emerge from Lincoln Electric. First, the reward sys- tem uses as an input the output from the performance-evaluation system—the two sys- tems are linked. Second, Lincoln Electric uses both quite objective and explicit (units produced) as well as subjective (dependability and cooperation) performance mea- sures. Third, Lincoln managers failed to understand that all three components of the firm’s organizational architecture must remain in balance. They naively believed that Lincoln’s successful performance evaluation and reward systems could be exported to foreign countries. But European labor laws, labor unions, and culture are quite dif- ferent than in the United States. An effective organizational architecture in the United States must fit within the constraints imposed by both the domestic legal sys- tem as well as U.S. culture. Simply exporting an organizational architecture without modification into a different legal and cultural environment is likely to fail.
Employee performance is evaluated for at least two reasons. First, performance evaluation provides employees with feedback on job achievement that provides im- portant information on how they might improve performance. For instance, addi- tional training in particular areas might be indicated. Second, performance evalua- tion is used in determining rewards and sanctions—wages, raises, bonuses, promotions, reassignments, and dismissals. These two purposes create somewhat different incentives. For example, if evaluations were used exclusively to provide feedback, employees would have fewer incentives to distort their evaluations to make themselves look better. But distortions to improve reported performance are more likely if employees are rewarded based on measured performance.
In this chapter, we focus primarily on the second reason for performance evalua- tion—as input for setting rewards and sanctions for employees. This chapter as well as the next describes the performance-evaluation system, the third leg of our three- legged stool that constitutes the firm’s organizational architecture. Performance eval- uation involves evaluating both individual employees and subunits of the firm. This chapter focuses on individual performance evaluation. The next chapter examines issues in evaluating subunits within the firm.
To organize our discussion of individual performance evaluation, we return to the basic principal-agent model presented in Chapter 15. In that model, the employee’s output Q depends on effort e and a random component �:
Q � �e � � (16.1)
where � is the employee’s marginal productivity. For every unit of effort, � units of output are expected. In this model, e and � are unobservable by management, but � is known by both management and the employee. If the employee is paid a fixed wage, independent of output Q, the employee has incentives to shirk because low Q can be blamed on negative �, which is not observable. (Remember, effort is costly to the employee.) To limit such shirking, the firm bases employee compensation on output:
Employee compensation � W0 � �Q (16.2)
Chapter 16 Individual Performance Evaluation 505
where � represents the sensitivity of pay to performance. Such compensation con- tracts create incentives for employees to reduce their shirking on effort. But these contracts also impose risk on employees because pay is now a function of �, the ran- dom component in the production of output. Since the employee is risk-averse, the firm must compensate the employee for bearing this risk or else the employee will choose to work elsewhere. This additional compensation for bearing such risk is called a compensating differential. Thus, owners of firms must trade off the addi- tional effort the employees will exert from more powerful incentives with the larger compensating differential to bear this risk.
In this basic principal-agent model, output is assumed contractible; Q is an objective performance measure. The employee and the firm can execute compensa- tion contracts based on Q at relatively low cost. Hence, compensation and perfor- mance evaluation (two legs of the stool) are explicitly linked. The model implicitly includes the following assumptions:
• The principal knows the employee’s production function (Q � �e � �), but not the actual values for e and �.
• The principal benefits from higher Q (output).
• Output can be observed at zero cost.
• There is only one quantitative measure of performance—output.
• The employee produces a single output.
• The employee cannot game the performance measure.
• The employee works independently; there is no team production.
• Any mutually beneficial contract is feasible; labor markets are unregulated.
Clearly in practice, managers must implement performance-evaluation systems in situations that do not conform to some or all of these assumptions. The remaining sections of this chapter describe various issues that arise when these assumptions are relaxed.
Setting Performance Benchmarks Solving for the optimal � in Equation (16.2) requires management to know � in Equation (16.1). Since the employee’s marginal productivity is not readily observable, management must estimate it. To illustrate the issues involved in esti- mating the employee’s marginal productivity, consider the following simplified example. Conrad Mueller can assemble a particular model of welder at the following daily rate:
Units assembled � 5ec � �c (16.3)
where ec is the number of hours of normal effort worked, and �c is a random error term. If Conrad worked 8 hours at a normal effort level, ec � 8, then on average he would assemble 40 welders (5 � 8). On average, the error �c is zero. If Conrad worked 8 hours but at a faster, more strenuous pace (ec � 8)—the equivalent of, say, 12 hours at a normal effort level (ec � 12)—then 60 units per day would be assembled on average. If he slacked off and took numerous short breaks, ec might only be 5, and 25 units on average would be assembled.
While the average error �c is zero, the number of units assembled is subject to potentially large shocks; this means that the variance of �c is not zero. For example,
506 Part 3 Designing Organizational Architecture
if Conrad were to receive low-quality parts or subassemblies, the number of units assembled would be down even if Conrad were to expend normal amounts of effort (ec � 8) because more time would be required to fit together each slightly out-of- specification part. Or perhaps Conrad might be idled for a few minutes each hour waiting for parts delivery. In these cases, �c would be negative. Alternatively, he might get lucky and assemble more than 5ec units because of an unusually well-pro- duced set of parts, ample parts inventory, productive tools, or few distractions.
The assembly department in the preceding example might establish a benchmark of 40 welders assembled per employee per day. Production above 40 then would be considered good performance and less than 40 considered poor performance. The standard of 40 is absolute in the sense that it is fixed and known before the employee exerts effort. Management, however, might know neither the exact relation between effort and production (welders assembled � 5e � �) nor that the average employee exerted 8 units of effort a day. Thus, the output of the average assembler must be es- timated. There are at least two ways to do this: time and motion studies and histori- cal production data analysis.
Time and Motion Studies
In time and motion studies, industrial engineers estimate how much time a particu- lar task requires, with the goal of determining the most effective work method. Mo- tion studies involve the systematic analysis of work methods, considering the raw materials, the design of the product, the process, the tools, and the activity at each step. Besides focusing on how long a particular activity should take, industrial en- gineers often are able to redesign the product or process to reduce the time required. Time studies employ a wide variety of techniques for determining the duration a particular activity requires under certain standard conditions. Work sampling (one type of time study) involves selecting a large number of observations taken at ran- dom intervals and observing how long employees take performing various compo- nents of the job. Time and motion studies often are expensive in terms of engineer- ing time used in the studies. They usually must be redone whenever product design changes or new equipment is introduced. They also suffer from potential bias be- cause of employees’ incentives to establish lower quotas by underperforming dur- ing the study period.
Past Performance and the Ratchet Effect
Another common mechanism for setting performance goals uses historical data on past performance. Unfortunately, this method often leads to a perverse incentive called the ratchet effect.2 The ratchet effect refers to basing next year’s standard of performance on this year’s actual performance. But performance targets usually are adjusted in only one direction: upward. A poor year usually causes subsequent years’ targets to be reduced not at all, or to be reduced by very little. This “ratcheting up” of standards discourages employees from exceeding the quota substantially to avoid
2A. Leone and S. Rock (2002), “Empirical Tests of Budget Ratcheting and Its Effect on Managers’
Discretionary Accrual Choices,” Journal of Accounting & Economics 33, 43–67.
Chapter 16 Individual Performance Evaluation 507
raising the standard for future periods by too much.3 Many illustrations of dysfunc- tional behaviors induced by the ratchet effect exist:
• Companies often base a salesperson’s bonus on meeting target sales where the target is based on last year’s sales. If salespeople expect an unusually good year, they often will try to defer some sales into the next fiscal year. For instance, they might take the customer’s order but delay processing it until the next fiscal year.
• In the old Soviet Union, central planners would set a plant’s production quota based on past experience. Plant managers meeting their targets received vari- ous rewards, and those missing the target were punished. This created incen- tives for managers to exceed the quota just barely.
• In one automobile engine assembly plant, a labor productivity performance goal was mandated each year. Each department’s target was based in part on last year’s performance plus an increase. This created incentives for managers to defer making big productivity improvements in any one year, preferring in- stead to spread them over several years.4
Lincoln Electric avoids the dysfunctional problems of the ratchet effect by its pol- icy that the piecework rate cannot be changed even if the employee is making too much money. Once a piecework rate is set by the time study department, it is never changed until production methods or processes are changed, or unless the employee challenges the rate and a new time study is conducted.
Another way to reduce problems caused by ratcheting up each year’s performance targets is more frequent job rotation. If you know that next year someone else has to meet the sales figures you achieve this year, you will sell more now. However, job rotation can destroy job-specific human capital such as customer-specific relationships.
Measurement Costs When it is costly to observe the employee’s output, performance evaluation becomes much more complicated—and interesting. For example, your server at the restaurant might appear to have performed well. But you only begin to suspect that you were served caffeinated instead of decaffeinated coffee at 2 A.M. when you still cannot sleep. The quality of a patent attorney’s work is not known until a challenge to the patent is filed. Measuring an elementary schoolteacher’s output is complex. Relying on standardized test scores captures only a part of student learning. Or, a research scientist’s output is difficult to quantify and observe. “Observability,” “verifiability,” and “contractibility” ultimately are questions of cost. Almost everything is observ- able—even effort—at some cost. For example, in jobs where physical effort is required, how hard an employee works might be measured by attaching heart-rate monitors or videotaping the person. But, such measurements frequently are quite costly.
3Some of the incentive not to exceed the target by a large amount is reduced if the employee’s bonus is a
function of the amount by which output exceeds the target. The actual dysfunctional incentives created by the
ratchet effect depend on the precise form of the incentive compensation contract. For example, if past
performance is used to set � in Equation (16.2), very different incentives are created than if past performance
is used to set a target performance and a fixed bonus is paid so long as actual output exceeds this target. 4R. Kaplan and A. Hutton (1997), “Peoria Engine Plant (A),” Harvard Business School Case 9-193-082.
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Costs are incurred in generating performance measures. For example, accounting systems must be developed and maintained to keep track of sales, costs, quality, or divisional profits. Computer systems and software capable of producing detailed re- ports are more complicated. And if the measures are used for performance evalua- tion, additional management and clerical time must be spent ensuring the accuracy of the performance measures. High measurement costs can lower the net benefits of tying pay to performance.
In our simple principal-agent model, the employee’s output is used in setting compensation. However, output depends on random factors. Even if output were costlessly observable, it still can be optimal to expend additional resources to measure the employee’s effort level more precisely. To the extent the firm can re- duce the employee’s exposure to the variance of these random factors via more sophisticated performance measures, the lower the compensating differential the firm must pay the employee to bear this risk. The informativeness principle im- plies that whenever low-cost information is available that allows a more accurate assessment of the employee’s effort, such information should be used in assessing performance. A value-maximizing firm will go to the point where the incremental cost of increasing the precision of its performance measurement (through more sophisticated accounting and information systems, for instance) equals the incremental benefits. These benefits include the reduction in the risk premium that must be paid to employees.
In general, the more incentive pay in the employee’s compensation package, the more risk the employee bears and the more the firm should spend on measurement systems to quantify the impact of these random factors. Thus, the choice of the optimum � in Equation (16.2) and the choice of how much to spend measuring performance are jointly determined. These two legs of the stool are complements. Increasing the employee’s incentive compensation � should be accompanied by increasing the precision with which effort is measured.5
In some cases, observing and measuring the employee’s output becomes so ex- pensive that the firm begins to look for alternative proxies that capture employee per- formance. For example, managers often are evaluated on the accounting profits of their divisions, even though the firm ultimately is interested in the total value created
Measuring What Counts Determining the weight of an orange may be a low cost, accurate operation. Yet what is weighed is seldom what is truly
valued. The skin of the orange hides its pulp, making a direct measurement of the desired attributes costly. Thus the
taste and amount of juice it contains are always a bit surprising.
Source: Y. Barzel (1982), “Measurement Cost and the Organization of Markets,” Journal of Law & Economics XXV, 27–48.
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5For a more formal treatment of this principle, see P. Milgrom and J. Roberts (1992), Economics, Organizations, and Management (Prentice Hall: Englewood Cliffs), 226. Firms sometimes can reduce the risk imposed on employees by basing pay on available input-based measures, such as hours worked, number of customers contacted, and new accounts created, than on output-based measures used in the basic model.
Input-based measures, however, are generally less effective than output-based measures in encouraging
employees to use their specific knowledge efficiently and thus are less desirable when local specific
knowledge is important. See M. Raith (2008), “Specific Knowledge and Performance Measurement,” RAND Journal of Economics, 39, 1059-1079.
Chapter 16 Individual Performance Evaluation 509
by its managers. This value includes not only short-term divisional profits (as mea- sured by the accounting system) but future expected profits, as well as the effects of the manager’s efforts on other divisions’ profits. Similarly, schoolteachers often are evaluated on their students’ performance on standardized tests, even though the school ultimately is interested in broader, harder-to-measure indicators of learning. Whether or not a particular proxy variable is good for purposes of performance eval- uation depends on whether the employee’s actions have similar effects on both the proxy variable and the underlying output variable.6 For example, if paying a man- ager on divisional profits motivates more diligent effort as well as actions that increase underlying value, then divisional profits would be a useful performance measure. Alternatively, to the extent divisional profits motivate actions that do not enhance value (e.g., sacrificing substantial future profits to achieve only a modest increase in near-term profits), divisional profits are a poor performance measure. Ill-designed performance measures promote opportunism and gaming.
Opportunism In our basic model, the agent is paid based on what the principal cares about—the employee’s output, Q. As previously discussed, it may be feasible only to evaluate the agent on some alternative measure, which we label here as Y. Paying the agent on Y provides incentives to the agent to take actions to increase Y, which can be very dif- ferent than the actions to increase Q—you get what you pay for. Imperfect perfor- mance measures often provide incentives to employees to behave opportunistically in ways that affect their performance evaluations. This section describes two exam- ples of opportunistic behavior: Gaming and the horizon problem. Almost all perfor- mance measures suffer from these and other related problems (discussed later in this chapter). How heavily the firm should weight a performance measure, such as Y, de- pends on the magnitude of these problems compared to the increase in Q that the firm obtains in return.
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Technology to Reduce Measuring Costs of Individual Performance Companies often use technology to evaluate individual performance. British Airways uses employee performance
software to track how long their customer service representatives spend resolving customer complaints or issuing
tickets. The software also tracks how many customers call back complaining about errors in their tickets or
complaining that their previous complaint calls were not addressed satisfactorily, so ticket agents don’t slough off in
issuing the original ticket. Other software blocks employee nonbusiness chatting, surfing, shopping, and instant
messaging. Firms use these systems to provide extra incentives to those employees whose digital records merit the pay.
This is an example of how a reduction in the cost of measuring individual performance leads to a more precise estimate
of employees’ effort, thereby reducing the risk employees bear from random events (or errors) in measuring their
performance, and thus increasing the proportion of incentive pay in their compensation package.
Source: M. Conlin (2002), “The Software Says You’re Just Average,” BusinessWeek (February 25), 126; and L. Kornblatt (2007), “Zihtec Introduces Innovative Software to Help Companies Control Online Productivity,” Business Wire (April 16).
6G. Baker (1992), “Incentive Contracts and Performance Measurement,” Journal of Political Economy 100, 598–614.
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Gaming
For simplicity, suppose that Q � action 1 � � and Y � action 1 � action 2 � �, where � and � are random shocks. While compensating an employee on Y can provide in- centives for the employee to take action 1, it can also provide incentives for the em- ployee to take action 2, even though it does not affect the firm’s return, Q. This action is a pure social waste, and if the employee is paid a competitive wage (for attraction and retention) the cost is borne entirely by the firm. For example, suppose Q is a divi- sional manager’s unobservable true contribution to firm value, while Y is the observed accounting earnings of the division. The manager’s exertion of productive effort (action 1) contributes to both Q and Y, while engaging in questionable accounting choices (action 2) affects only Y. Evaluating the manager on divisional earnings can provide incentives to the manager to waste his time and other resources manipulating divisional accounting and place the firm at risk of possible regulatory actions. In a more extreme case, such as Q � action 1 � � and Y � action 2 � �, a contract based on Y will motivate no increases in Q. This is true even as in this example the two mea- sures are perfectly correlated since they share a common noise term, �. For instance, a police department might want a policeman to concentrate on arresting truly reckless drivers and having them convicted by a court of law (Q � the number of convicted truly reckless drivers), while the policeman is evaluated on the number of arrests and subsequent convictions of drivers who simply exceed the basic speed limit (Y). Whether a ticketed driver is convicted or not in all cases depends solely on which judge is randomly assigned to the case (some judges are more likely to convict than others). Here Q and Y would be highly correlated, but evaluating the policeman on Y would provide very limited incentives to concentrate on arresting truly reckless drivers. Ar- resting any driver who exeeds the speed limit increases his performance measure.
Recall the costs Merrill Lynch incurred when its analysts inappropriately recom- mended securities to its customers. Doing so increased the analysts’ incomes but was extraordinarily damaging to Merrill. Other examples include the following: A sales- person offers customers discounts to shift sales from one evaluation period to an- other. An employee paid based on output reduces quality to increase output. A refuse hauler, compensated on the weight of trash delivered to the landfill, uses a fire hose to top off his load with water before weighing in at the truck scales. Finally, Lincoln
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Gaming Objective Performance Measures Dysfunctional behavior of mortgage originators appears to have been one cause of the financial crisis of 2007–2008.
Specialists and brokers, who did not provide the funding directly, originated most mortgage loans in the United States.
They sold the originated loans to other financial institutions and thus were rewarded based on the number and size of the
originated loans. Under this system, originators can have limited incentives to insure that a loan is a good one, since the
costs of default are largely borne by other parties. Some contracts between financial institutions and originators allow the
mortgage to be “put” back to the originator if the homebuyer defaulted on the loan within some limited time period, for
example, during the first year. Various mortgage originators gamed this provision prior to the crisis by promoting loans
that offered below market interest rates for the first year (“teaser rates”). The low interest rate reduced the mortgage
payment for the first year, limiting near-term defaults. The rate of defaults tended to be higher in year two and beyond
when the interest rate was increased to actual market levels and the borrower could no longer afford to make the payments.
Source: M. Baily, R. Litan and M. Johnson (2008), “The Origins of the Financial Crisis,” Business and Public Policy at Brookings (November).
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Electric installed counters to record the number of characters typed by their secre- taries who were paid on this basis. But piecework for secretaries was abandoned when one secretary, who earned much more than the others, was found staying at her desk during lunch and coffee breaks depressing a repeating key on her keyboard, thus quite rapidly typing totally useless pages. Hence, seemingly objective measures of performance such as sales or output often create incentives for employees to take value-reducing actions (such as lowering product quality) if such actions increase their measured performance.
Performance evaluation almost always involves unintended consequences that often benefit the agent at the firm’s expense. Jobs are complex and often involve several tasks, some of which are difficult to contract over. One particularly poignant example involves Ken O’Brien, the football quarterback who early in his career in the 1980s tended to throw interceptions. He was given a contract that penalized him for each interception. The unintended consequence was he frequently refused to throw the ball and ended up getting sacked or not throwing the ball when he should have.7
Horizon Problem
Objective output measures frequently focus on the near term because of the diffi- culty of objectively measuring consequences that might occur in the future. Short-run, objective performance measures can cause employees—especially those about to change jobs or leave the firm—to concentrate their efforts on pro- ducing results that will influence their appraisals favorably over their remaining horizon with the firm. For example, a 64-year-old salesperson, paid on commis- sion and expecting to retire at age 65, has little incentive to work at developing long-term customer relationships.
Relative Performance Evaluation Multiple employees performing similar tasks potentially can provide useful addi- tional signals about the random errors affecting individual employees. For example, if in addition to Conrad, Dina van den Brink also assembles welders and her output is
Units assembled by Dina � 5ed � �d (16.4)
where ed is the number of hours of normal effort worked by Dina, and �d is her ran- dom error term. In assembling welders, both Conrad and Dina expect that if they exert average effort of e � 8, each expects to produce 40 units. If Conrad’s and Dina’s error terms, �c and �d, are positively correlated because they depend on many of the same conditions (raw material quality and working conditions), then in evalu- ating Conrad’s performance, management can look at Dina’s output for information about uncontrollable factors affecting Conrad’s production. If Dina were to have un- usually low output, it is likely that there was some shock that would have lowered Conrad’s output, as well.
More generally, suppose that in addition to Conrad and Dina, a number of other employees also assemble the same welders. The informativeness principle implies that an important source of information about an employee’s effort is the output of coworkers performing similar tasks. Thus to reduce the risk of noncontrollable fac- tors, management uses information about the average number of welders assembled
7C. Prendergast (1999), “The Provision of Incentives in Firms,” Journal of Economic Literature (May), 21.
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by all these employees. Forty units per employee per day is the expected number of welders, given normal quality and no unusual events. Suppose the average number of welders across all the employees on a given day was 43. Then for this day, average � � 3(43 � 40). And if Conrad produced 41 welders that day, his compensation would be adjusted by some part of his two-unit shortfall (41–43). Using the output of other employees to adjust the employee’s output in the compensation contract is called relative performance evaluation. By filtering out common shocks from em- ployee incentive pay, relative performance evaluation reduces the risk employees bear. This allows the firm to reduce the risk premium it must pay employees to bear this common risk, thereby reducing the firm’s total labor costs. (The appendix to this chapter discusses methods to estimate the optimal adjustment.)
Within-Firm Performance
Using other employees’ output within the same firm to estimate the average error is a useful method of reducing the risk employees bear from incentive compensation con- tracts if they all sell or manufacture the same products and face the same competitors and economywide factors. However, forming a reference group from employees in- side the firm also can have drawbacks. Only in rare cases are employees’ jobs identi- cal. For instance, some salespeople have large established territories—others, small developing ones. Customer types can vary dramatically across sales territories.
If an internal reference group is formed and its group average is used to assess normal performance, the group has incentives to punish “rate busters”—extremely productive employees who raise the average. In a classic research study known as the Hawthorne experiments, employees were observed hitting colleagues who exceeded the commonly accepted output rate.8 Thus, explicit employee collusion to hold down the benchmark can occur. Also, instances of sabotage are observed in relative performance evaluations. Instead of working diligently and increasing their own
Relative Performance Evaluation for CEOs CEO compensation (salary plus bonus) and turnover likelihoods depend on relative performance evaluation. Gibbons
and Murphy examine 2,214 CEOs serving in 1,295 large, publicly traded U.S. corporations from 1974 to 1986. They
find that CEOs’ compensation is positively related to their own stock return performance and negatively related to the
stock return in the market and industry. That is, compensation is higher when the CEO’s own firm’s stock return is
higher and when the market or industry stock return is down. Finally, they study the likelihood that the CEO is
replaced. Executive turnover is lower the larger the firm’s own stock price return and the lower the industry return. If
the industry is performing poorly, the CEO is more likely retained, holding everything else constant. However, CEOs
also are compensated using awards of stock and options. The realized values of these awards are adjusted for overall
market or industry performance only rarely. Thus, although some of the incentives of executives are based on relative
performance, others are based on absolute performance. Another study of CEOs of large publicly traded firms from
1993 to 2003 also reports that CEOs’ compensation is positively related to their own stock return performance and
negatively related to a peer group’s stock return. (Albuquerque uses industry and size to construct peer groups.)
Source: R. Gibbons and K. Murphy (1990), “Relative Performance Evaluation for Chief Executive Officers,” Industrial and Labor Relations Review 43, 30S–51S; and A. Albuquerque (2005), “Who Are Your Peers?” doctoral thesis, University of Rochester.
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8H. Parsons (1974), “What Happened at Hawthorne?” Science 183 (March 8), 927.
Chapter 16 Individual Performance Evaluation 513
performance, coworkers sabotage their peers within the reference group. Alterna- tively, employees might try to get themselves classified into a reference group that has weak performance so they will appear above average.
Relative performance evaluation also affects recruiting incentives. Employees often are involved in interviewing and selecting potential colleagues. If paid based on relative performance, such employees have the incentive to recommend hiring less competent new employees. This improves the relative performance of the cur- rent employees.
Across-Firm Performance
The Securities and Exchange Commission requires publicly traded firms when de- scribing their executive compensation to select a benchmark reference group of other firms and report how their firm has performed relative to that benchmark. This is an example of selecting a reference group outside the firm. Some firms also employ ex- ternal benchmarking to overcome the lack of an internal reference group or to avoid the pernicious actions of sabotage and collusion. Firms exchange information di- rectly or do so through a trade association that aggregates information across several firms to mask individual firm data. Sometimes this information is obtained from compensation consultants that aggregate information across client firms. Thus, aver- age performance in other firms is used as the reference group.
There are several disadvantages to external benchmarking. Use of this method often is precluded by a lack of data: Other firms view their performance data as pro- prietary and thus are unwilling to share it. Even if firms are willing to share data, for firms in the same industry such cooperation is potentially illegal under antitrust laws, and although job titles might be similar, the assignment of decision right can differ profoundly between firms. Moreover, employees in outside firms may not be subject to the same common shocks as the benchmarking firm’s employees. Thus, external benchmarking might increase the risk to employees, rather than decrease it.
Subjective Performance Evaluation Most jobs contain numerous dimensions. For example, baseball players have to field the ball, get hits (ranging from bunts to home runs), run the bases, and generally support the team. It is difficult to specify and measure all aspects of the job. If com- pensation is based on explicit measures that capture only some aspects, employees
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Classic Example—Potential Costs of Relative Performance Evaluations Individuals gaming performance-evaluation systems are not uncommon. Some people are willing to go to great lengths
to sabotage others when their advancement is based on relative performance evaluations. For example, one reporter
told of a friend who recently had been promoted at a large bank. When asked about it, the friend confessed that he had
hacked into the bank’s computer system and gained access to employees’ messages as well as their calendars. “They
would miss important meetings and be sent on wild-goose chases, only to look like complete buffoons when they
showed up for appointments that were never made.” By the time these poor fellows realized that their careers had been
derailed, they were reporting to a new vice president.
Source: J. Dvorak (1988), “New Age of Villainy,” PC Magazine (September 27).
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will deemphasize the unmeasured job attributes. For instance, if a veteran ballplayer is evaluated solely on his hitting, he has fewer incentives to spend time mentoring young ballplayers. Often, the firm augments its use of objective, explicit measures of output and uses more subjective yet comprehensive measures of performance. A key feature of subjective measures is that they cannot be verified by third parties.
Firms decentralize decision rights to individuals in the firm, in part to encourage them to participate in the conversion of wetware into software. Firms often use sub- jective performance evaluation to provide employees with greater incentives to take their skills and insights (wetware) and systematize them into valuable methods, for- mulas, or recipes (software). This software then can be leveraged throughout the organization. Many firms have formalized mechanisms to accomplish these goals, such as “Suggestion Boxes” to solicit ideas for improving organizational productivity.
Subjective performance reviews are conducted primarily because it is expensive to measure accurately all the dimensions of the employee’s output that are valued by the firm. Subjective evaluations provide a more holistic view of an employee’s per- formance because objective evaluations often exclude difficult-to-observe job tasks, or because the relative weights needed to aggregate objective evaluations change with current circumstances. In fact, it is rare for employees to be evaluated exclu- sively based on objective measures. Rather, their performance evaluations tend to in- clude subjective elements. For example, most employees receive annual perfor- mance reviews from supervisors. These reviews often form the basis for setting salaries and promotions. Even when compensation is based entirely on objective measures (piece rates in agriculture), the firm reserves the right to fire employees for low-quality production, tardiness, inability to get along with coworkers, or other dys- functional behavior. Lincoln Electric bases factory employees’ wages entirely on piecework—an objective measure. But in addition to this objective measure, Lincoln also uses a subjective merit evaluation to set the employee bonus, which is approxi- mately the same magnitude as wages.
We first describe an important reason firms use subjective performance measures— namely, assigning multiple tasks to employees. Then various subjective evaluation systems are described. Finally, problems with subjective evaluations are summarized.
Multitasking and Unbalanced Effort
Multiple tasks often are assigned to one employee because there are efficiency gains from bundling the tasks. For example, secretaries answer phones, word process, file, schedule appointments, and make travel plans. Or, an employee might be expected to sell products to existing customers, contact potential new customers, and fill out sales reports. These tasks all are complementary to selling the product.
Returning to the comparison of Q (what the firm actually cares about) and Y (the available performance measure), suppose that Q � task 1 � task 2 � � and Y � task 1 � �. In this case, a contract based on Y creates incentives to undertake the first task, but cannot create incentives to undertake task 2. If the firm wants the employee to devote effort to the second task, it must not use Y as its only measure of the employee’s performance.9
9S. Datar, S. Kulp and R. Lambert (2001), “Balancing Performance Measures,” Journal of Accounting Research, 39, 75–92; and G. Feltham and J. Xie (1994), “Performance Measure Congruity and Diversity in Multi-Task Principal/Agent Relationship,” Accounting Review 69, 429–453.
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Suppose, for example, that Conrad Mueller performs two tasks, assembling welders and training new employees to assemble welders. Some activities are more easily measured, such as counting the number of welders Conrad assembles; others, like training new assemblers, are more difficult to assess. If Conrad’s evaluation is based primarily on the easily measured tasks (welders assembled), he has incentives to concentrate his efforts on these activities. Conrad will not allocate the optimal amount of time to the other unmeasured tasks. Remember: You get what you pay for—and frequently, that is all you get.
This multitasking problem can affect optimal job design. For example, a firm might want to have certain employees concentrate only on assembling welders when complementarities among tasks are low. These employees then could be evaluated on their output of assembled welders. Other employees would concentrate on train- ing new assemblers and correspondingly be evaluated on their training. By separat- ing the tasks, each employee can be given more focused incentives to perform their more limited range of tasks.
Subjective reviews evaluate an employee’s performance on a more comprehensive basis. Aspects of the job that are measured less easily can be considered along with more easily measured activities. For example, the supervisor might consider the em- ployee’s efforts at being cooperative, being part of a team, being responsive to po- tential customers, or filling out reports accurately. Conrad’s supervisor can observe how he instructs new hires, how patient he is, and how they ultimately perform as as- semblers in assessing Conrad’s performance as a trainer. Moreover, if Conrad games the performance measure—takes firm-value reducing actions that increase the objective performance measure—his supervisor (if aware of these dysfunctional actions) can penalize Conrad through his subjective performance evaluation.
Subjective Evaluation Methods
There are two widely used subjective performance-appraisal systems: Standard- rating-scale systems and goal-based systems. Goal-based systems tend to be more explicit and less subjective than standard-rating-scale systems.
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Self-Evaluation Self-evaluation by the employee, that is, reviewed by the boss often forms a basis for compensation adjustments and
promotions. In self-evaluations, employees enumerate accomplishments, discuss weaknesses, and point out strengths.
One employee views the self-evaluation as a way to inform her boss about how she brings value to the company.
Although she realizes that the self-evaluation is an opportunity to highlight her contributions to the company,
she agonizes over the task. Ultimately there are only two major ways that you end up describing yourself:
“(A) Self-flagellating lummox dumb enough to enumerate weaknesses that can be used against you at a later date.
(B) Self-aggrandizing egomaniac who thinks no means yes, insults are a form of flattery—and you’re pretty good
looking to boot.”
Self-evaluations can be unreliable and certainly are controversial tools. High self-esteem leads to grade inflation.
Eighty-five percent of self-evaluators rate themselves in the top 25 percent. Females do not inflate as much as males.
Overraters tend to make more money and get more promotions but have lower performance and shorter careers.
Source: J. Sandberg (2003), “Better than Great—And Other Tall Tales of Self-Evaluations,” The Wall Street Journal (March 12).
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Standard-Rating-Scale Systems Standard rating scales require the evaluator to rank the employee on a number of different performance factors using, for example, a five-point scale: Far exceeds requirements, exceeds requirements, meets all requirements, partially meets requirements, does not meet requirements. The different performance factors judged vary across firms and positions within firms but often include the following:
• Achieves forecasts, budgets, objectives
• Organizes effective performance through oral and written communications
• Sets and attains high performance goals for self and group
• Updates knowledge of job-related skills
• Emphasizes teamwork among subordinates
• Identifies and resolves problems
• Evaluates subordinates objectively
• Ensures equal opportunities for all subordinates
After ranking the employee on each of these narrow criteria, the evaluator then assigns a rating for the overall job: Excellent, better than satisfactory, satisfactory, needs further improvement, and unsatisfactory. Most subjective performance ap- praisals contain a section where the supervisor provides detailed comments on the employee’s strengths and weaknesses and offers specific recommendations for im- provement and further development.
Goal-Based Systems In a goal-based system, each employee is given a set of goals for the year. For exam- ple, goals might be “hold training sessions for all employees in the department by No- vember 1,” or “hire four additional qualified members of minority groups.” These goals tend to be more objective and easier to measure than the more vague perfor- mance factors used in the standard rating scales such as “emphasizes teamwork.” Nonetheless, these goals still are more subjective than standard piecework measures. At the end of the year, the supervisor writes a memo detailing the extent to which each goal has been met. An overall evaluation of the employee is based on the extent to which the goals are achieved.
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360-Degree Performance Reviews Privately held W. L. Gore & Associates with sales of $2.3 billion in 2007 employs 8,000 employees and manufactures
Gore-Tex waterproof fabric. Often ranked among the “100 Best Companies to Work for in America,” all Gore
employees are called associates. There are no “bosses,” but each employee is assigned a “sponsor” who acts as a
mentor. Gore has been using 360-degree evaluation as part of its performance feedback since 1958. Under this system,
annual evaluations are gathered on all associates from the individual’s peers, subordinates, and superiors. The
evaluations are anonymous and rate employees on their contributions to the success of the business during the past
year. All ratings on each employee receive equal weight. Compensation committees composed of sponsors with
specialized knowledge of the area use the rankings to award pay increases or performance warnings.
A vice president of marketing at a large telecommunications company was told by her employees in a 360-degree
review that “you are angry a lot.” “That feedback was a life-altering experience for me,” she reports.
Source: C. Hymowitz (2003), “Managers See Feedback from Their Staffers as the Most Valuable,” The Wall Street Journal (November 11); J. Reingold (2007), “A Job That Lets You Pick Your Own Boss,” http://money.cnn.com (October 8); and www.gore.com.
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After evaluators have rated their employees using either a standard rating scale or a goal-based system, evaluators usually then review the evaluations with their supervisors. This helps ensure the accuracy of the review and promotes consistency of criteria across employees. After reviewing their evaluations, employees can respond to the evaluation in writing, including the expression of formal disagreement with any of the specifics in the appraisal. Finally, the evaluators and their supervisors review the feedback provided by the evaluators and the employees’ responses.
In the majority of cases, the employee’s immediate supervisor does the perfor- mance evaluation. In some cases, firms have experimented with peer evaluations— especially in situations where teams are important. The benefit of peer evaluations is that peers have information about typical performance in group assignments and the actual contribution of the individual to the team. Offsetting the better specific knowl- edge of peers is the added costs of training everyone in the team to do evaluations. Moreover, peer evaluation can increase the tensions within the team. For example, some team members might systematically lower everyone else’s ratings to make themselves look better. Or, friends may be rated highly to increase their chance of being promoted to supervise their former colleagues. Finally, teammates might de- cide to collude to give everyone higher performance ratings.
Frequency of Evaluation Most subjective performance evaluations are conducted yearly, primarily because most salary adjustments are made annually. The benefits of more frequent evalua- tions (say quarterly) unlikely offset the higher costs. However, there are some exam- ples of more frequent review. For example, new hires typically receive more frequent evaluations; often a new employee is evaluated at the end of three months. During this probationary period, the firm must decide whether to keep the individual. Also during this period, frequent feedback helps the employee learn and improve perfor- mance. As another example, consultants are evaluated after each professional as- signment by the partner-in-charge of the engagement. Especially where team com- position changes from project to project, capturing performance-evaluation information on a timely basis is important. The person’s performance is known, and there is no reason to wait until the end of the year. Moreover, the evaluation provides more timely information on which to base subsequent project assignments.
Problems with Subjective Performance Evaluations
There are several potential problems with subjective performance evaluation.
Shirking among Supervisors10
Disciplining employees and informing them of their shortcomings often are un- pleasant tasks. Supervisors do not capture the full wealth effects of these actions. Hence, potential shirking among supervisors leads to the provision of inaccurate per- formance evaluations. The inaccuries can take several forms. Supervisors overstate the poor performers. That is, the supervisor is too lenient. A supervisor might be re- luctant to give adverse ratings to avoid conflict with subordinates. A supervisor also might overrate poor employees’ performance to promote their transfers to new
10C. Prendergast and R. Topel (1993), “Discretion and Bias in Performance Appraisals,” European Economic Review (June), 355–365; C. Prendergast and R. Topel (1996), “Favoritism in Organizations,” Journal of Political Economy 104 (October), 958–978.
518 Part 3 Designing Organizational Architecture
positions in other parts of the firm. In other cases, supervisors compress ratings around some norm rather than distinguish good and poor performers. Or, a supervisor might rank employees based on personal likes and dislikes rather than on job performance. Bias adds noise to the performance-evaluation system; it typically reduces morale and consequently the employees’ incentives to work diligently, thereby lowering overall firm performance.
Indirect empirical evidence suggests that managers tend to assign relatively uni- form performance ratings to employees. In a study of 7,000 performance ratings of managers and professionals in two firms, the researchers report that 95 percent of all appraisals were in just two categories: Good and superior (outstanding).11 A survey of employee attitudes at Merck & Co., a large U.S. pharmaceutical firm, reported the following attitudes:12
• Managers are afraid to give experienced people a 1, 2, or 3 rating. It’s easier to give everyone a 4 and give new people a 3.
• Charlie’s been in that job for 20 years. He hasn’t done anything creative for the last 15 years. Do you think my manager would give him a 3 rating? No way! Then he’d have to spend 12 months listening to Charlie complain.
• What’s the use of killing yourself? You still get the same rating as everyone else, and you still get the same 5 percent increase. It’s demoralizing and demotivating.
This evidence suggests that low-rated, disgruntled employees can impose costs on supervisors. In response, supervisors have incentives to bias their evaluations. As a result, performance ratings are frequently inaccurate appraisals of the employee’s true performance. Biased, inaccurate appraisals reduce the incentive of employees to improve their performance by working harder and can lead to the promotion of less qualified people. Here, the problem lies not in the evaluation system per se, but rather in the incentives for the evaluators.
At Lincoln Electric, supervisors have incentives to do a good job because they are evaluated and compensated on the job they do in evaluating lower-level employees. Also, employees can discuss their ratings with senior management. Problems of bias are likely to be lower if the supervisor is held accountable for the future performance of individuals who are promoted based on the supervisor’s recommendation.
Forced Distributions To overcome the tendency to rate all employees “above average,” some firms impose a forced distribution where a fixed fraction of employees are assigned to each cate- gory (i.e., the supervisor must rank a certain percentage of the employees as poor). However, forced distributions may not reflect the true distribution of performance accurately in each work group. Forced ranking systems can cause problems, espe- cially when the size of the group to be evaluated is small. For example, having to rank one of four employees as poor might force the supervisor to rate a good- performing employee as poor; inaccuracies from the forced distribution might be larger than those from a biased supervisor. Moreover, forced distributions do not necessarily reduce the costs imposed on the supervisor. Under a forced distribution,
11J. Medoff and K. Abraham (1980), “Experience, Performance, and Earnings,” Quarterly Journal of Economics 95, 703–736.
12Quotes excerpted from a 1985 Merck report by K. Murphy (1992), “Performance Measurement and
Appraisal: Motivating Managers to Identify and Reward Performance,” in W. Bruns (Ed.), Performance Measurement, Evaluation, and Incentives (Harvard Business School: Boston), 37–62.
Chapter 16 Individual Performance Evaluation 519
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Microsoft Abandons “Stack Rankings” During the 1980s, many firms copied General Electric’s “rank-and-yank” system that was implemented by
then prominent CEO Jack Welch. Welch argued, “some think it’s cruel or brutal to remove the bottom 10 percent
of our people, but it isn’t. There is no cruelty like waiting and telling people late in their careers that they don’t
belong.”
More recently, a relatively large number of prominent companies have abandoned rank-and-yank systems. For
example, in late 2013 Microsoft Corporation announced that it was abandoning major elements of its controversial
“stack ranking” employee review and compensation system. These rankings historically had been key factors in
promotions and in allocating bonus and equity awards at Microsoft. Many current and former Microsoft employees
complained that the system often resulted in capricious rankings, power struggles among managers, and unhealthy
competition among colleagues. General Electric, itself, moved away from forced employee ratings under Welch’s
successor Jeffrey Immelt.
While the general trend appears to be away from forced rating systems, many firms continue to use them.
According to one consultant at least 30 percent of Fortune 500 firms continue to rank employees along a curve, doing so under softer sounding names, such as “talent management.”
Source: S. Ovide and R. Feintzeig (2013), “Microsoft Abandons ‘Stack Ranking’ of Employees,” The Wall Street Journal (November 12).
supervisors might assign ratings based on the potential costs employees will impose on them—not based on the employees’ true performances.
Influence Costs Influence costs include those nonproductive activities employees engage in to in- fluence outcomes—in this case, politicking for higher ratings by their supervisor. One potential method of reducing these costs is to rotate supervisors or employees more frequently (getting on the good side of one supervisor is of limited benefit). Rotation of employees, however, can limit potential synergies and cost reductions that arise with repeated interaction between a given manager and employee. New supervisors have limited knowledge of employees’ specialized skills. Also, more frequent rotation potentially increases total influence costs, since the employee has more lobbying opportunities.
ANALYZING MANAGERIAL DECISIONS: Semco S.A.
Semco S.A. in São Paulo, Brazil, has 500 employ-
ees and manufactures capital goods. The
employees elect their managers and evaluate them
every six months. Managers rated poorly are trans-
ferred or fired. There are 100 nonunion employees
who set their own performance standards and
arrange their own work schedules. Twice a year,
the nonunion employees receive a market salary
survey and are asked to set their own pay for the
next six months. Employees setting their pay too
low receive that amount, as do employees request-
ing too high a salary. If management decides after
one year that the employees’ salaries were above
what they were worth to the company, these em-
ployees are fired. The 400 unionized employees’
pay is set by union contract. Critically evaluate
Semco’s performance-evaluation system.
520 Part 3 Designing Organizational Architecture
Reneging There is the potential that the firm will renege on promises to employees to reward good performance. For example, management might promise to give raises to those who perform well. Afterward, management might unjustifiably assert that work was poor and renege on the promised raise. It is less likely that an employee will be suc- cessful in a lawsuit involving subjective performance measurement than when the employee can document that a firm reneged on an explicit contract involving ob- jective performance measures.
Managers in healthy firms generally have incentives to maintain good reputa- tions for honoring implicit contracts. However, reneging on implicit contracts will appear most attractive to firms in financial difficulty (near bankruptcy). Reneging also can occur when a supervisor has a short horizon with the firm and is compen- sated on business-unit profits. (Unit profits might be increased in the short run by not granting raises to employees.) We discuss these issues further in Chapter 22.
Combining Objective and Subjective Performance Measures Performance-evaluation systems generally fall on a continuum between the two extremes—objective and subjective evaluation systems. Objective measures con- sist of items like output and sales that can be quantified easily and thus explicitly measured. Objective measures can be used in formal contracts between the em- ployee and the firm. Subjective measures consist of noncontractible judgments about employee performance (the year-end evaluation from a supervisor). Subjec- tive measures are used in implicit contracts. Few job-performance measures are
M A N A G E R I A L A P P L I C AT I O N S
Tips on Subjective Performance Reviews Here are some tips for improving your next performance evaluation:
• Prepare a list of creative ways you are solving problems with limited resources. For example, to reduce travel
costs you have been holding fewer, but more comprehensive, meetings.
• Show how your work bolsters the bottom line. For example, instead of requesting new computers because they
are state-of-the-art, frame the request as the new computers will save 10 percent of operators’ time.
• Focus on the future. Instead of dwelling on past failings, emphasize specific future plans, such as training
programs to attend.
When appraising others:
• Give honest feedback. Don’t rate problem employees as above average because of fear of confrontation. This
merely prolongs and exacerbates the inevitable confrontation.
• Ask employees if they understand their current assignments, if they have any problems, or stresses.
• Focus on the future, upcoming goals, potential training opportunities, instead of dwelling on the past.
• Communicate the company’s goals and shifting priorities via the performance review.
PPG Industries illustrates how one company implements many of the above suggestions. PPG uses “SMART goals”
for employee objectives. SMART is an acronym for Specific, Measurable, Agreed-upon by employee and manager,
Realistic, and Timebound. Instead of simply telling a sales manager to boost sales next year, a SMART goal would be:
“Develop, by May 1, three new customers in the Eastern region with annual sales potential of $50,000.”
Source: S. Scherreik (2001), “Your Performance Review: Make It Perform,” BusinessWeek (December 17), 139–140.
Chapter 16 Individual Performance Evaluation 521
purely objective or purely subjective; most measures involve mixtures of both. In most cases, organizations that use objective measures also use subjective measures to evaluate the same employee (as does Lincoln Electric, e.g.). Investment bankers pay bonuses based on fees generated by the employee but also use subjective mea- sures such as the “quality of the deals.”
Both objective and subjective performance measures can be inaccurate measures of the employee’s contribution to the firm’s value. As the accuracy of either measure de- creases, more weight will be placed on the other in determining performance (holding its accuracy constant). As the accuracy of each measure decreases, the risk the employee bears increases, as does the compensating differential the employee must be paid.13
Besides being inaccurate, both objective and subjective measures can induce var- ious dysfunctional behaviors. We indicated earlier that objective measures can create incentives for gaming, that reduces the firm’s value as in the case of the policy “churning” by an insurance agent (convincing a policyholder to use the accumulated cash value to purchase a new, larger policy). If supervisors shirk when writing sub- jective performance reviews, employees’ incentives to work diligently are reduced. Also, employees will generate influence costs lobbying for higher subjective ratings. Finally, implicit contracts using subjective measures are more easily abrogated by the firm than formal contracts based on objective measures. Employees must trust that the firm will not renege on implicit contracts. An important constraint on the firm from reneging is its reputation. Thus, firms facing a greater likelihood of finan- cial distress will find subjective evaluations more costly to use.
Because the costs and benefits of objective and subjective measures vary across jobs, in some situations primarily objective measures are observed, others are mix- tures of both, and in other cases, primarily subjective performance measures are ob- served. Each firm will face specific costs and benefits of objective and subjective measures and will tailor its performance measures to its circumstances. Moreover, the costs and benefits are likely to vary over various divisions of the firm and jobs. However, employees performing similar tasks in similar industries tend to have similar performance-evaluation systems because the costs and benefits of alterna- tive evaluation methods will be similar.
Both objective and subjective performance measures are costly. The larger these costs, the less firms tend to rely on performance evaluations for setting rewards and punishments. Paying employees straight salary and giving simple cost-of- living raises to all employees will lead to predictable shirking and other incentive problems. Yet these costs still can be lower than the costs of implementing a per- formance-based incentive plan.
Team Performance Teams frequently are used at all levels of the organization. Teams are formed be- cause they are more successful at assembling specialized knowledge for decision making than are alternative methods that might be used to pass the knowledge through the traditional hierarchy. For example, many companies often form new product development teams composed of people from engineering, marketing, man- ufacturing, finance, and distribution as a way to assemble the knowledge required to design, manufacture, and sell profitable products. As discussed below, teams also
13See C. Prendergast (1999), “The Provision of Incentives in Firms,” Journal of Economic Literature 37 (March), 7–63, for a survey of the relevant papers.
522 Part 3 Designing Organizational Architecture
can prove useful particularly when one employee’s productivity affects the produc- tivity of other employees. For instance, one complaint by employees at Lincoln Elec- tric is that their pay suffers when employees ahead of them on an assembly line are unable to keep them supplied with work.
Team Production
To illustrate the performance measurement problems of teams, again consider welder assemblers Conrad Mueller and Dina van den Brink. To simplify the notation, assume they exert a common effort level e, whether in a team or not. If they work in- dependently, their individual output is
Individual output � 5e � � (16.5)
where e represents the individual effort of either Conrad or Dina and � is a random error term with zero mean and positive variance. If Conrad and Dina work as a team, they produce
Team output � 4e 2 � � (16.6)
For e � 2.5, the expected output working as a team is higher than the output of working independently:
Expected team output � 4e 2 � Expected individual output � 5e � 5e (16.7)
As displayed in Figure 16.1, Conrad and Dina’s team output always is larger than the sum of their individual outputs whenever they each exert 2.5 units of effort (they jointly exert 5 units of effort).
In this example, there are team-production effects: Output is potentially higher when Dina and Conrad work as a team. Team output can be larger because Dina and Conrad help each other. Large, awkward pieces can be attached in less than half the time by two people assisting each other than if they worked independently. In other cases, team output is larger than individuals working separately because the team is able to the different specialized knowledge of its members.
M A N A G E R I A L A P P L I C AT I O N S
Increased Use of Quantifiable Performance Measures A relatively large number of U.S. businesses overhauled their performance evaluation systems following the
2008–2009 recession in an attempt to better separate top performers from under achievers. One common change was to
move from using a mix of objective and subjective performance measures to basing reviews only on quantifiable
measures. According to Hewitt associates 10 percent of managers and 11 percent of other employees in U.S.
companies were evaluated solely on quantifiable results in 2010, rather than on a combination of hard figures and
softer behavioral characteristics. These estimates were up from 7 percent to 8 percent, five years earlier. The move
toward quantifiable measures was motivated in part by commonly observed biases in subjective evaluations. One chief
human resources officer noted that at his company the old, subjective evaluations had led to the corporate equivalent of
grade inflation: “The chance of earning a good score was almost guaranteed.”
While quantitative measures have certain advantages over subjective evaluations, they are also subject to gaming
and can cause problems in multitask environments (“you get what you are paid for”). Therefore, it is not surprising
that the vast majority of firms continue to use a mix of quantifiable and subjective measures in evaluating employees.
Source: J. Light (2010), “Performance Reviews by the Numbers,” The Wall Street Journal (June 29).
Chapter 16 Individual Performance Evaluation 523
E xp
e ct
e d
o u
tp u
t
25
Conrad’s and Dina’s individual effort levels
2.5
Conrad and Dina’s team output
Sum of Conrad’s and Dina’s
individual outputs
e
QFigure 16.1 Comparing Individual and Team Outputs
When Conrad and Dina each exert at least 2.5 units of effort, their team output is greater than their outputs working independently.
M A N A G E R I A L A P P L I C AT I O N S
Peer Pressure within Teams Levi Strauss, maker of Levi jeans, installed multitask teams in its U.S. plants, replacing the old piecework system.
Each team had 20–30 employees responsible for completing individual orders by assembling full pairs of pants, instead
of each employee specializing as a zipper sewer or a belt-loop attacher. In essence, jobs were redesigned from being
functional to being more multitask and process-oriented (recall Chapter 13’s discussion). The much touted move was
designed to empower workers, cut down on monotony, reduce stress, and increase productivity.
Employee incentive compensation was based on team output, which created free-rider problems, which in turn
led to absenteeism and shirking, which caused tempers to flare. Supervisors on the plant floor spent more time
intervening to prevent “big fights.” One plant manager reported, “Peer pressure can be vicious and brutal.” Before
installing the multitask teams, each employee received two weeks of training in group dynamics and an additional
one-day seminar in “let’s-get-along sessions” with private consultants. These training sessions did not resolve the
conflicts. In fact, productivity dropped and costs rose. The quantity of pants produced per hour worked fell in 1993
to 77 percent of preteam levels. At one plant, the cost of stitching a pair of Dockers went from $5 before teams to
$7.50 with teams.
Then, Levi’s share of the domestic men’s denim-jeans market fell from 48 percent in 1990 to 26 percent in 1997.
In 1997, Levi closed 11 U.S. plants and laid off 6,400 employees. While vowing to preserve the team strategy at its
remaining U.S. plants, many of them unofficially went back to individual piecework. Robert Haas, Levi’s CEO, admits,
“teams created pressures and tensions and a lot of unhappiness, and some people would rather go back. Ours is a
culture of experimentation and novelty, and we’re not always successful.” Between 1997 and 2004, Levi Strauss closed
45 plants and laid off 27,000 employees. In 2007 it operated five plants in Europe and Asia-Pacific and none in North
America.
Source: R. Mitchell (1994), “Managing by Values,” BusinessWeek (August 1), 50; R. King (1998), “Levi’s Factory Workers Are As- signed to Teams and Morale Takes a Hit,” The Wall Street Journal (May 20), A1; and Levi Strauss & Co., Form 10-K, Securities and Exchange Commission (February 12, 2008).
524 Part 3 Designing Organizational Architecture
Evaluating Teams
Teams are formed because of their joint production effects.14 These team production effects make evaluating the performance of individual team members quite compli- cated. Although often there is no measure of individual output—only team output is observed—it normally is optimal to evaluate team members, at least in part, on team output. Using team output focuses team members on a common objective and helps promote cooperation. However, paying team members on group output provides indi- viduals with incentives to free-ride. These incentives are less pronounced in smaller teams. But as team size grows, these free-rider problems can become enormous.
Free-rider problems can be controlled by evaluating team members not only on team output but on other measures as well. For instance, the following factors might be used to assess performance by Conrad and Dina: the number of hours worked, a su- pervisor’s subjective evaluation as to how hard they are working, the condition of their tools, and peer evaluations. Peer evaluations consist of Dina’s evaluation of Conrad’s work and Conrad’s evaluation of Dina’s work. Peer reviews often are important in evaluating the individual performance of team members because it is teammates who have the specific information about how each team member has performed.
Sometimes the costs of controlling free-rider problems within teams exceed the benefits that come from team production. In this case, it is better to work individu- ally rather than as a team. For instance, if evaluating Dina and Conrad on team out- put provides low incentives to exert effort and the costs of monitoring individual per- formance of teammates (e.g., through supervisor or peer reviews) are high, the net value of their combined output might be higher with individual production and performance evaluation.
One of the key tasks for new teams is to develop the internal architecture for the team. Decision rights (task assignments) must be partitioned among the team mem- bers. Accordingly, members must decide how to evaluate the work efforts of team members. Finally, members must decide on the rewards and punishments for mem- bers of the group. Sometimes the rewards and punishments are social; for example, a shirking member may be ostracized.
14A. Alchian and H. Demsetz (1972), “Production, Information Costs and Economic Organization,” American Economic Review 62, 777–795.
ANALYZING MANAGERIAL DECISIONS: Why Teams Fail
Along with Mom and apple pie, teamwork has
become a sacred cow to American businesses. Yet,
one survey by Mercer Management found that only
13 percent of 179 teams received high ratings.
“Somehow, we have to get past this idea that all we
have to do is join hands and sing Kum Ba Yah and say, ‘We’ve moved to teamwork.’” Many companies
are narrowing the focus and time horizon of teams.
A team manager at Texas Instruments counsels that
not everyone has to be on a team and that only
5 percent of its workforce are on self-directed
teams. Harvard Professor Amy Edmonson questions
whether many firms “might be barking up the
wrong tree” in stressing the use of teams: “I’ve
begun to think that teams are not the solution to get-
ting the work done.” Discuss potential reasons why
teams often fail to deliver the hoped for results.
SOURCE: E. Neuborne (1997), “Companies Save, But Workers Pay,” USA Today (February 25), 1B; and M. Starvish (2012), “Why Leaders need to Rethink Teamwork,” Forbes.com (December 28).
Chapter 16 Individual Performance Evaluation 525
As another example of evaluating team output, consider the case of student pro- ject teams in business school courses. Such projects build leadership skills and teach students how to work more effectively in teams. These projects also enhance learn- ing by allowing students to share their understanding and by helping all students on the team to learn more than if they each did the project individually. Instructors as- signing projects to study teams frequently give the same grade to all members of the team. Thus, the team is evaluated based on the team’s joint output.
Rather than assign all the members of the team the same project grade, some in- structors apportion the total project grade among the team members based on peer reviews where unequal grades for teammates are possible. Thus, although the over- all project’s grade might be a B�, some team members might receive an A� and others a B so long as the average across the team is a B�. Providing the team with the decision rights to evaluate one another reduces the free-rider problem and in- creases team production. But it can also reduce morale and lead to increased influ- ence costs as team members lobby one another for better evaluations. Or, some team members might downgrade a team member unfairly to raise their own grades. These dysfunctional incentives are likely to be greater if the team is formed for a single pro- ject. As described in Chapter 10, free-rider problems are smaller if the team spans several courses and students have more incentives to invest in their reputations.
Government Regulation of Labor Markets The basic principal-agent model assumes that both parties are free to arrive at any mutually agreeable contract and that labor markets are unregulated. However, gov- ernment regulates labor markets and hence constrains the agreements employees and firms might otherwise reach. Since the 1960s, federal laws in the United States deal- ing with affirmative action and equal employment opportunity (EEO) have had a profound effect on both performance-evaluation systems and reward systems. Fed- eral and state legislation and court actions have forced companies to document their compensation and promotion decisions to demonstrate that their actions are related to performance and are not influenced by the employee’s race, religion, sex, age, or national origin.
Labor laws and court decisions have had a material impact on the performance- appraisal systems. In deciding cases involving alleged discriminatory employment practices, courts look more favorably at companies with the following characteristics:15
• The firm’s job descriptions are clearly written and well defined.
• The appraisal system has clear criteria for evaluating performance such as written objective scales and dimensions.
• There are specific written instructions on how to complete the performance appraisal.
• Employees are provided feedback about their performance appraisal.
• Higher-level supervisors’ evaluations are incorporated into the appraisal system.
• Individuals who receive similar evaluations in the firm are treated equally and consistently.
15Major federal legislation includes the Equal Pay Act of 1963, Title VII, and the Civil Rights Act of 1964. A.
Barnes, T. Dworkin, and E. Richards (1994), Law for Business (Richard D. Irwin: Burr Ridge), Chapter 23; G. Milkovich and J. Newman (1993), Compensation (Richard D. Irwin: Burr Ridge), 316–318.
526 Part 3 Designing Organizational Architecture
Although these characteristics appear sensible, even worthwhile for many firms, government regulation has negative side effects. The law does not permit companies and employees to “opt out” of these regulations. Even if these characteristics were appropriate and would be adopted voluntarily by the majority of firms, they are im- posed on all firms and hence impose costs on that minority that would not have cho- sen them voluntarily.
The presence of potential legal scrutiny of the firm’s performance-evaluation sys- tems pushes these systems to become more formal, more objective, with less reliance on subjective appraisal. Every personnel action and appraisal must be documented. The firm’s human resources department typically assumes the role of ensuring that the firm is complying with the labor laws.
The performance-appraisal system that meets these regulatory criteria would not necessarily maximize the firm’s value absent the regulation. For example, many Japanese managers try “to make everybody feel that he is slated for the top position in the firm”16 by delaying differentiating among cohorts and performance appraisals for 12–15 years after joining the firm. Such limitations on annual feedback to em- ployees potentially would run afoul of affirmative-action laws in the United States and thus would be opposed strenuously by human resources departments at most large corporations. Hence, U.S. firms find it more difficult to use less formal, more subjective performance-evaluation systems than their foreign competitors, even though such systems might be value-enhancing for some firms if they could operate in a less regulated setting.
The U.S. tax code [Internal Revenue Code Section 162(m)(4)] limits the annual income tax deduction for compensation paid to high-ranking executives of publicly traded companies to $1 million. However, this $1 million income tax deduction lim- itation is waived if the amount of compensation over $1 million is “performance based.” In order for the firm to be able to deduct executive compensation paid above $1 million as a tax expense, the compensation above $1 million should be tied to at- taining one or more “performance goals.” In order to qualify, the performance goals must be approved by the compensation committee of the board of directors. Also, the performance goals and the applicable corporate officers’ compensation package must be disclosed to, and approved by, a majority of the shareholders. And, before any compensation is paid, the compensation committee of the board of directors must confirm that the performance goal has been met.
Government regulations, including tax laws, cause U.S. firms to spend more money than they would otherwise on appraisal systems that, to a court’s satisfaction, document the firm’s compliance with affirmative-action regulations. Thus, regula- tions likely cause some U.S. firms to adopt different performance-appraisal systems.
The United States is not the only country with government regulations governing their labor markets. For example, France has a complex set of rules regulating the circumstances companies must face before firing employees, how long French com- panies must wait before terminating various types of employees, severance payments that must be offered, and so forth. For example, French companies must prove that “permanent” employees are being terminated for “economic reasons,” and engineers must be given three months’ notice. French companies with 50 or more employees wishing to close a plant must provide the government with a “social plan” that places
16N. Hatvany and V. Pucik (1981), “Japanese Managerial Practices and Productivity,” Organizational Dynamics 13, 4. Also, M. Aoki (1988), Information, Incentives and Bargaining in the Japanese Economy (Cambridge University Press: Cambridge).
Chapter 16 Individual Performance Evaluation 527
a limit on the total number of layoffs and provides reemployment and/or retraining of terminated employees.17 While such laws increase the costs of French employees, they also encourage firms to hire “temporary” workers who can be terminated more easily, to outsource jobs to other countries or to smaller French firms, and to substi- tute capital for labor.
The U.S. and French labor laws are other examples of how regulation affects the firm’s optimal choice of organizational architecture. Web Chapter 21 (available via Connect), describes government regulation more generally and provides additional organizational architecture examples.
Summary In the previous four chapters, we have examined the first two components of organiza- tional architecture: the assignment of decision rights and the reward systems. In this chapter, we began to examine the third component: the performance-evaluation system.
Performance evaluation is conducted for both individuals within the firm and sub- units of the firm: How did Taylor perform? How did Morgan’s team perform? Such questions require individual and team performance evaluations. Also, Morgan and Taylor are in the automotive products division. How did this division perform? Answering this last question requires divisional performance measures. This chapter focuses on individual performance-evaluation systems; divisional performance eval- uation is discussed in Chapter 17.
The simple principal-agent model in Chapter 15, suggests that part of the em- ployee’s compensation should be based on performance (output). But basing pay on output requires that output is observable at low cost and is difficult to manipulate by the firm or the employee. Among the costs of performance measures are the compensating differentials employees must be paid for bearing the additional risks of incentive pay. Moreover, the model assumes that the firm and employee are free to contract in an unregulated labor market. This chapter explores how individual per- formance evaluation is affected when these conditions are violated.
To set the optimum compensation package, management must know the em- ployee’s marginal productivity of effort. One way managers estimate these marginal productivities is to use time and motion studies or data on past performance. If past performance is used, dysfunctional incentives due to the ratchet effect can result; employees will limit output if they anticipate that the next period’s target benchmark will be raised. To reduce the dysfunctional consequences of the ratchet effect, some firms set performance estimates at the beginning of the period and do not adjust them simply because employees are making high earnings.
In some cases, measuring output can be extremely costly. For example, accurately measuring the output of a teacher is likely to be quite costly. Firms will select perfor- mance evaluations based on the direct cost of the measure, the cost of employee opportunism induced by the performance measure, and the indirect cost incurred by imposing more risk on the employee.
Another assumption of the model is that the employee shirks only on effort. If output is not correlated perfectly with the firm’s value, employees attempting to increase output might cause the value of the firm to decline. Such dysfunctional results can occur when employees game the system—as in the Prudential Insurance Company agents case of “churning” policies.
17F. Kramarz, and M. Michaud (2004), “The Shape of Hiring and Separation Costs,” Forschungsinstitut zur
Zukunft der Arbeit Institute for the Study of Labor, IZA Discussion Paper No. 1170 (June).
528 Part 3 Designing Organizational Architecture
Often a manager has multiple signals available regarding the employee’s output. The informativeness principle suggests that the manager should use all these signals (so long as they are available at low cost) because they allow the firm to reduce the risk the employee bears and hence lower the compensating differential the employee must be paid. The informativeness principle suggests that when several employees are performing similar tasks, their combined output provides informa- tion about common random shocks affecting all their outputs. Thus, the employee’s compensation should be adjusted relative to peers. This is called relative perfor- mance evaluation. Relative performance evaluation requires the firm to establish a reference group of employees to use as a benchmark. But relative performance evaluations can lead employees to collude or sabotage coworkers to improve their evaluations. Moreover, establishing the appropriate reference group and measuring its performance is costly.
In some cases, the measurement costs or the costs from employees’ dysfunctional attempts to maximize explicit performance measures become so great that alterna- tive measures of performance are sought. Subjective performance evaluations are periodic reviews by supervisors that usually incorporate a comprehensive examina- tion of all the employee’s outputs. Subjective evaluations can be based on either stan- dard rating scales for a number of different areas or goal-based systems. Standard rating scales have the appearance of objectivity but entail subjective judgments by the evaluator. Goal-based systems set performance targets at the beginning of the pe- riod that the evaluator uses at the end of the period to determine an overall, subjec- tive evaluation.
Subjective performance measures also involve costs. It becomes easier for a man- ager or the firm to renege on the promise to reward good performance because it is harder to define “good.” There is more latitude to exercise favoritism and introduce bias in subjective measures. Finally, subjective systems often generate greater influ- ence costs as employees try to lobby for better ratings.
Subjective and objective performance evaluations usually complement each other. Subjective evaluations often are used to reduce the incentives of employees to en- gage in opportunistic behaviors that increase the costs of objective measures. For ex- ample, the Lincoln Electric secretary who typed meaningless characters during lunch could be penalized using a subjective system: The supervisor could dismiss the secretary or give the secretary a poor subjective evaluation.
Teams often are formed as a way to assemble knowledge held by individual team members. No one individual has all the knowledge necessary to perform the task. When employees work in teams, each individual’s marginal contribution to the team’s output depends on others’ efforts. There are synergies or interdepen- dencies among employees. Measuring individual output is difficult, and it is costly to disentangle individual shirking from others’ effort. Evaluating teams of employees usually requires a measure of team performance while still recogniz- ing individual contributions to the team. Individual performance (possibly mea- sured using peer reviews) is rewarded to overcome free-rider problems. In some cases, each team member’s bonus is based on individual performance, but the bonus is paid only if the entire team reaches its goals.
The principal-agent model assumes that the parties are free to contract, yet labor laws constrain their choices. The EEO laws in the United States have had a pro- nounced effect on performance-evaluation systems. For example, defending against affirmative-action lawsuits has encouraged firms to adopt more explicit, objective appraisal systems than they otherwise might have chosen voluntarily.
Chapter 16 Individual Performance Evaluation 529
A. Alchian and H. Demsetz (1972), “Production, Information Costs and Economic Organization,”
American Economic Review 62, 777–795.
G. Baker, R. Gibbons, and K. Murphy (1994), “Subjective Performance Measures in Optimal
Incentive Contracts,” Quarterly Journal of Economics CIX, 1125–1156.
G. Baker, M. Jensen, and K. Murphy (1998), “Compensation and Incentives: Practice vs. Theory,”
Journal of Finance 63, 597–616.
Y. Barzel (1982), “Measurement Cost and the Organization of Markets,” Journal of Law & Economics XXV, 27–48.
R. Gibbons and J. Roberts (2013), “Economic Theories of Incentives in Organizations,” The Hand- book of Organizational Economics, Edited by R. Gibbons and J. Roberts (Princeton University Press, Princeton NJ), 56–99.
E. Lazear and S. Rosen (1981), “Rank Order Tournaments as Optimal Labor Contracts,” Journal of Political Economy 89, 841–864.
G. Milkovich and J. Newman (2007), Compensation (Irwin/McGraw-Hill: Burr Ridge).
C. Prendergast (1999), “The Provision of Incentives in Firms,” Journal of Economic Literature 37 (March), 7–63.
16–1. Martina Genser sells copiers for Xerox. Her sales are a function of her effort e and can be expressed in the following manner:
Sales � 100e � �
where � is a random error term with expected value of zero. Martina’s personal cost of ex- erting effort is
C(e) � e2
She is paid a straight salary plus a commission:
Compensation � $1,000 � 0.10 sales
Her personal objective is to maximize
U � E (Compensation) � C(e)
the difference between the expected value of her compensation and her cost of effort.
a. Find Martina’s optimal effort level. b. Now assume that Xerox compensates Martina based on her sales relative to the average
sales for salespeople in the company. Assume that Martina’s sales are not included in
the calculation of this average and that she cannot affect the average sales through her
effort. The expected value of average sales is 500. Her compensation is now
Compensation � $1,000 � 0.10(sales � average sales)
Calculate Martina’s optimal effort level under this compensation plan.
c. Including average sales in the contract affects expected compensation. What adjustment must be made in the salary to keep expected compensation the same as before?
d. Does including average sales in the compensation contract affect the variance of Martina’s compensation? Assume that her sales and average sales are positively
correlated. Give a brief verbal explanation to support your answer.
16–2. The Quantum Division of Nextel Corp., based in San Jose, California, manufactures semi- conductors that convert analog signals to digital signals. Lynn Kraft is the division manager.
Her compensation consists of a base wage of $50,000 plus a bonus of 2 percent of division
profits above $10 million. Last year’s division profits were $12 million, and so Kraft re-
ceived a bonus of $40,000.
Self-Evaluation Problems
Suggested Readings
530 Part 3 Designing Organizational Architecture
This year two things happened that adversely affected division profits. First, the price of
gold, a key ingredient in Quantum’s chips, increased dramatically, causing the division’s
costs to be higher than expected. Second, an earthquake in the San Jose area caused Quan-
tum’s plant to be closed for six weeks and to require $1 million in repairs. Division profits
for this year were $9 million.
Kraft believes her compensation plan should be adjusted for these events. She believes
that, but for these events, division profits would have been $13 million for the year.
a. What issues should the CEO of Nextel consider when deciding whether to adjust Kraft’s bonus plan?
b. Do you think the plan should be adjusted? Why?
Solutions to Self-Evaluation Problems 16–1. Xerox Salesforce Compensation
a. Her objective is to maximize U � 1,000 � .10(expected sales) � e 2 � 1,000 � .10e � e 2. The solution can be found by elementary calculus, graphically, or through iteration. The
answer is e* � 5. b. The answer is still e* � 5. The new term (.10 � average sales) is not affected by effort.
The marginal benefits and costs of effort remain the same.
c. Expected compensation is reduced by 50 by including the term in the compensation contract. This can be offset by increasing the base salary to $1,050.
d. Yes. High (low) average sales are associated with high (low) �/s. Appropriately weighted, including average sales in the contract reduces the variance of compensation
by filtering out part of the random shock, �.
16–2. Bonus Plan Adjustment
a. Making Kraft’s compensation sensitive to such uncontrollable events increases the riski- ness of her compensation. If Kraft is risk-averse, the firm will have to pay her a com-
pensating differential for the compensation risk she is being required to bear. The firm
must decide whether the (present value of the) compensating differential is greater or
less than the increase in firm value as a result of making Kraft responsible for such
events.
b. Why might it be value increasing for the firm to make Kraft accountable for such events. It is true that she cannot control those events. However, there are things she can do to
minimize the consequences of the events. She can hedge against fluctuations in gold
prices, and she can buy earthquake insurance. (It is not clear, however, that the cost of
such hedging and insurance is greater than the benefits to the firm.) You will see more
discussion of these issues in corporate finance. More importantly, Kraft can take actions
after such events that reduce the costs to the firm. For example, after the earthquake,
Kraft probably could have made a number of decisions that shortened the amount of time
the plant was closed. If Kraft is not held accountable for the costs of the earthquake, then
she has no incentive to take such cost-reducing (value-increasing) actions.
There is also the issue of influence costs. If the firm decides not to hold Kraft ac-
countable for such events, then Kraft has incentives to argue that a lot of costs are as-
sociated with the events (i.e., more costs than actually were associated with the event).
She will also argue that a lot of events were uncontrollable. Senior managers must
therefore devote energy to determining which events were uncontrollable and which
were not, and which costs were associated with the events and which were not. The
firm does not incur these costs if they adopt the policy of making Kraft accountable for
profits regardless of unforeseen events.
16–1. Discuss some of the costs and benefits of 360-degree evaluation systems.
16–2. In 360-degree performance review programs, personnel evaluations are collected anony- mously from employees knowing the manager being evaluated (superiors, subordinates,
and coworkers). These are tabulated and a consensus summary is provided to the manager.
Review Questions
Chapter 16 Individual Performance Evaluation 531
Each manager being evaluated also does a self-evaluation, and this is used to benchmark
how closely the manager and the coworkers’ assessments match. About one-third of the
managers match their coworkers, one-third have an inflated view, and one-third rate
themselves lower. Those who overrate themselves tend to be judged “least effective” as
perceived by their coemployees. However, these overraters are more common higher up
in the organization.18
a. What does the breakdown of three one-thirds indicate? b. Offer some plausible explanation of why overraters are higher up in the organization.
16–3. The following quote is based on statements made by quality expert W. Edwards Deming:
If by bad management the components of a company become competitive, the system is destroyed. . . . A common example lies in the practice of ranking people, divisions, teams, comparing them, with reward at the top and punishment at the bottom. Jobs and salaries are based on comparisons. Teams naturally become competitive; divisions be- come competitive. Each tries to outdo the other in some competitive measure. The re- sult is higher costs, battle of market share. Everybody loses.19
Do you agree with Deming that performance evaluations based on comparative rank-
ings always reduce company value? Explain.
16–4. The U.S. Navy recently revamped its officer fitness report system.20 Under the old system, officers were ranked into one of four categories, where 4.0 was the highest grade. This old
system had been used for 20 years and grade inflation had become rampant. Eighty per-
cent of all sailors routinely were ranked a perfect 4.0. One officer remarked, “Let’s face it,
85 percent of the people are 4.0 and 80 percent [of those] have every mark in 4.0.” A re-
tired admiral commented, “The old system wasn’t entirely broke, it was just deteriorating
over time and became less and less useful.”
The Navy decided to change the evaluation system because of the natural tendency for
senior officers to promote their own subordinates over unknown sailors. Not everyone
deserved a 4.0, but to get their own people promoted, senior officers had to play along
because that’s what everyone else was doing.
The new system requires each officer to be rated on a 1–5 scale in seven areas: profes-
sional expertise, leadership, support for equal opportunity programs, military bearing and
appearance, teamwork, mission accomplishment, and interpersonal skills. The total points
out of 35 possible are then used to provide an overall promotion recommendation:
• Clearly promote
• Must promote
• Promotable
• Progressing
• Don’t promote
The number of ratings in the top two categories—“clearly promote” and “must
promote”—will be severely restricted to at most 20 percent of the evaluations. If an officer
is evaluating 10 junior officers, at the most only two can receive the top two ratings.
What are the expected consequences of this new system? What are the likely
outcomes? What are the pros and cons of the new system?
16–5. Evaluate the following statement:
The overarching purpose of a measurement system should be to help a team, rather than senior managers, gauge its progress. A team’s measurement system should primarily be a tool for telling the team when it must take corrective action.21
18J. Lopez (1994), “A Better Way?” The Wall Street Journal Supplement (April 13), R6. 19R. Aguayo (1990), Dr. Deming: The American Who Taught the Japanese about Quality (Fireside Simon &
Schuster: New York), vii–viii. 20E. Blazar (1995), “The New Standard of Excellence,” Navy Times (March 20), 12–14. 21C. Meyer (1994), “How the Right Measures Help Teams Excel,” Harvard Business Review (May–June), 96.
532 Part 3 Designing Organizational Architecture
16–6. The Green Shoe Company is considering going to a piece-rate system, where manufac- turing employees are paid based on their level of output. Discuss what factors the firm
should consider in deciding whether this idea should be implemented. How should
the initial piece rate be set? Under what circumstances should the company alter the
piece rate once it is adopted?
16–7. Your company currently has a bonus plan for its sales managers. If annual sales for a man- ager’s unit exceed $1 million, the manager receives a $10,000 bonus. In a typical year,
about five of the 10 managers in the firm meet the target and receive the bonus. However,
the number receiving the bonus varies from year to year due to the state of the economy,
which in turn has an effect on sales. The company is considering replacing the bonus plan
with a plan that rewards the top-five selling managers each year with a $10,000 bonus.
Discuss the potential benefits and costs of the new plan relative to the old plan.
16–8. Communities are frequently concerned about whether police are vigilant in carrying out their responsibilities. Several communities have experimented with incentive compensa-
tion for police. In particular, some cities have paid members of the police force based on
the number of arrests that they personally make. Discuss the likely effects of this com-
pensation policy.
16–9. A consultant does not like the fact that you use subjective performance measures in your firm. He argues that they are arbitrary and should be replaced with objective measures.
He stresses that objective measures provide a clear target for employees, but mentions
none of the potential costs. What are the potential problems associated with using objec-
tive performance measures?
16–10. Some firms have recently adopted 360-degree performance evaluations. Under this evalua- tion system, the employee is evaluated not only by supervisors and peers but also by em-
ployees who report to the employee being evaluated. Discuss why a firm might want to
adopt 360-degree reviews. What are the likely problems with this type of performance
evaluation?
16–11. Evaluate the following quote:
Teams do not spring up by magic. Nor does personal chemistry matter as much as most people believe. Rather, we believe that . . . most people can significantly enhance team performance. And focusing on performance—not chemistry or togetherness or good communications or good feelings—shapes teams more than anything else.22
16–12. A basic principle in accounting is that of “responsibility accounting.” Under this principle, it is inappropriate to base performance evaluation on measures that are beyond the control
of the employee. Do you think that you should ever include variables in a workers’ com-
pensation plan that are not under at least partial control of the employee? Explain.
16–13. Bob’s Manufacturing Company has altered the determinants of pay raises for U.S. em- ployees. Whereas in the past pay increases for managers, professionals, and hourly work-
ers had been automatic, starting last year the company began determining the size of an
annual bonus pool and then allocated lump-sum bonuses to employees on the basis of
performance. Hourly workers were to be evaluated within their annual performance ap-
praisals; professional-level employees would work with their supervisors to establish per-
sonal goals against which they would be measured.
a. What problems do you foresee with the implementation of this arrangement? Be spe- cific about who will be affected by the problems you’ve identified.
b. What recommendations would you offer to top management at Bob’s Manufacturing Company to preempt or minimize problems with the new reward system?
16–14. Agricultural workers are often paid piece rates. For example, pear pickers are paid a fixed amount for each box of pears they pick. Pear companies, however, pay tree thinners on an
hourly basis. These thinners remove excess fruit from trees so that the remaining fruit can
22J. Katzenbach, and D. Smith (1993), The Wisdom of Teams (Harvard Business School: Boston), 61.
Chapter 16 Individual Performance Evaluation 533
grow larger. (Each piece of fruit must be at least six inches apart on the tree.) Why do you
think these companies pay thinners by the hour? Presumably, they would work harder if
they were paid by the tree.
16–15. Evaluate the following statement:
I am a manager at a governmental agency. I have no control over compensation policy. All workers are paid the same salary, and I cannot fire them. Therefore, an understand- ing of the basic principles of organizational architecture will not help me be more effec- tive in my job.
16–16. The JAB Gold Mining Company observes that some firms pay their CEOs based on per- formance relative to the S&P 500. Most firms, however, have stock prices that are posi- tively correlated with the S&P 500. JAB has a negative beta ! (Its stock returns are nega- tively correlated with the index.) Does this mean that JAB would be wrong in paying its
CEO based on performance relative to the S&P 500? Explain.
In this chapter, we argued that it can be optimal to base an employee’s pay on performance relative to some benchmark group such as employees within the same organization who perform similar tasks. The advantage of this type of system is that it filters out common shocks in the evaluation of employees and thus reduces the costs of inefficient risk bearing. In this appendix, we consider how a risk-neutral firm might optimally weight the performance of such a benchmark group in a compensa- tion contract.
For simplicity, we restrict our attention to simple linear compensation contracts of the following form:
Compensation � W0 � �(Q � � ) (16.8)
where W0 and � are fixed parameters, Q is the employee’s own output, and is the average output of the benchmark group (e.g., similar employees within the firm). W0 is the employee’s fixed wage under a relative performance contract. We are inter- ested in how to choose the optimal �. Note that if � � 0, average output receives no weight and thus is left out of the contract. In contrast, if � � 1, then compensation is based on a simple difference between own output and average output.
In the discussion that follows, we show that expected compensation can be held the same by simply adjusting W0. Second, under certain assumptions, the employee’s effort choice is independent of �. Third, we show how to choose � to minimize the risk the employee bears. Since expected compensation can be the same for any � and if the effort choice isn’t affected by �, then the efficient contract is the one that min- imizes the risk borne by the employee.
Expected Compensation Rewriting Equation (16.8) yields
Compensation � W0 � �Q � � �Q (16.9)
Expected compensation in Equation (16.9) is W0 � �E (Q ) � � �E( ) where E (�) denotes the expectation operator. Expected compensation can be held constant at any level of � by adjusting W0 by �� � E(Q ).
Q
Q
Q
Appendix: Optimal Weights in a Relative Performance Contract23
23Technical note: This appendix requires elementary knowledge of statistics, decision theory, and calculus.
Material in this appendix draws on the analysis in Milgrom and Roberts (1992), Chapter 10.
534 Part 3 Designing Organizational Architecture
Effort Choice Under certain assumptions, the employee’s effort choice is independent of �. In this case, the firm can choose � without being concerned about how it might affect em- ployee productivity. In particular, suppose that the employee’s cost of exerting effort is given by the function C (e ), which expresses the disutility of effort in dollar equiv- alents. The employee’s certainty equivalent can be approximated by the following formula:24
Certainty equivalent � E [W0 � �E (Q � � )] � 0.5r s 2 � C(e) (16.10)
where r is the coefficient of absolute risk aversion, and s 2 is the variance of com- pensation. In this expression, the first term on the right-hand side represents ex- pected compensation, the second term is the risk premium (employees discount the expected value because they are risk-averse), and the last term is the cost of effort. We make two additional assumptions: (1) the effort of the employee does not affect the average output of other employees of the benchmark group, and (2) r is a con- stant. Employees want to maximize their certainty equivalent with respect to the ef- fort choice e—which is equivalent to maximizing their utility. Conceptually, the maximizing effort level is found by taking the partial derivative of the certainty equivalent with respect to effort e and setting it equal to zero. The first-order condi- tion is therefore
�Q� � C �(e) (16.11)
where Q� and C �(e) are partial derivatives with respect to e. This expression indicates that the employee chooses the effort level that equates marginal benefits and mar- ginal costs. The marginal benefit is the extra compensation that the employee re- ceives from exerting more effort, and the marginal cost is the extra disutility that he experiences from working harder. Note that � does not enter into this equation, since the average output of other employees does not depend on this employee’s effort. Thus, in this case, the firm can choose any value for � without affecting the em- ployee’s effort level.
Minimizing Employee Risk Note from Equation (16.10) that the employee is made better off by reducing the variance of compensation (it lowers the discount for risk). The firm, on the other hand, is not harmed by this choice because the employee exerts the same effort level under any � and W0 can be adjusted to keep expected compensation the same. In- deed, the firm potentially can share in the gains from the risk reduction to the em- ployee by paying a lower expected level of compensation—since the firm can meet the employee’s reservation wage with a lower expected level of payout.
Basic statistics allows us to express the variance of compensation [Equation (16.8)] as
Var(Compensation) � �2[Var(Q ) � �2 Var( ) � 2�Cov(Q, )] (16.12)QQ
Q
24Technical note: A certainty equivalent is the amount of cash that employees would require with certainty to
make them indifferent between this certain sum and the uncertain income stream. The approximation of the
certainty equivalent in Equation (16.10) is a basic result from decision theory. It holds when the risk is small
and the utility function is sufficiently smooth. J. Ingersoll (1987), Theory of Financial Decision Making (Rowman & Littlefield: Totowa), 38.
Chapter 16 Individual Performance Evaluation 535
Figure 16.2 shows a picture of this quadratic function. The optimal weight is �* at the bottom of the parabola. Using basic calculus, we can show that
�* � Cov(Q, )�Var( ) (16.13)
Equation (16.13) has a quite intuitive interpretation. The numerator of the expression Cov(Q , ) is a measure of the association between this employee’s own output and the average output of other employees. The higher this association, the more information average output contains about random shocks that affect the employee’s output (the better is the “signal”). For example, if this covariance is zero, average output contains no information about these shocks and should not be included in the compensation contract. The denominator of the expression is the variance of average output. The higher this variance, the more noise there is in av- erage output and the less information it contains about the employee’s effort. The optimal weight �* can be estimated using a time series of observations on own out- put and average output.25
Firms sometimes base compensation on the simple difference between the em- ployee’s output and average output. This measure is equivalent to choosing � � 1. Our analysis indicates that this choice is not always optimal and in some cases can be worse than excluding average output in the contract (e.g., when the covariance be- tween the two variables is small). Indeed, the optimal weight could be negative if the two variables were negatively correlated.
Q
λ
V a
ri a
n ce
o f
co m
p e
n sa
ti o
n
s2
Weight on benchmark group performance in compensation plan
λ∗
Figure 16.2 Choosing the Optimal Weight in a Relative Performance Contract
This figure reflects a simple linear contract of the form Compensation � W0 � �(Q � � ), where W0 and � are fixed parameters, Q is the employee’s own output, and is the average output of the benchmark group (e.g., similar employees in the firm). Pictured is the variance of compensation as a function of �. Given the assumptions in the analysis, the optimal weight, �* � Cov(Q, )�Var( ). This is the value that minimizes the variance of compensation.
Q Q
25Technical note: Readers familiar with linear regression analysis should note that the right-hand side of
Equation (16.13) is the formula for the slope coefficient in a simple linear regression, where the employee’s
output is the dependent variable and average output of other employees is the explanatory variable. Thus,
this formula can be estimated through a simple regression.
536 Part 3 Designing Organizational Architecture
ANALYZING MANAGERIAL DECISIONS: Structuring Salesforce Compensation
Assume that a salesperson, Edwynn Phillips, has
the following annual compensation package:
C � $15,000 � 0.2(own sales)
This compensation plan induces Ed to exert a given
level of effort in selling. Given this effort level,
expected sales are $30,000 per year.
Below are 10 years’ worth of data for Ed’s sales
and the average sales for other employees in the
company (Ed’s own sales are excluded in calculat-
ing this average). The expected value of average
sales is also $30,000. However, in any given year,
average sales might rise or fall, depending on gen-
eral economic conditions, and so on. Some of these
same conditions affect Ed’s sales. Ed has no impact
on the average sales for other employees.
Year Ed’s Sales Average Sales
1 30,000 30,000 2 24,000 27,000 3 36,000 28,500 4 27,000 27,000 5 33,000 36,000 6 30,000 33,000 7 25,500 27,000 8 24,000 24,000 9 34,500 30,000
10 36,000 36,000
1. Based on the 10 years of data, calculate Ed’s
average annual pay and standard deviation
under the existing compensation plan.
2. Calculate Ed’s average pay and standard devia-
tion under the alternative plan:
$21,000 � 0.2(own sales � average sales)
Note: We adjust the intercept of the pay plan by $6,000 to reflect Ed’s average loss imposed
on the employee by subtracting 0.2 (average
sales) from the compensation. This adjustment
keeps the expected pay the same as before.
Also, the sample mean of average sales over a
10-year period need not equal the expected
value of $30,000.
3. Does including the average sales in the pay
package alter Ed’s incentives to work hard?
Explain. (Assume that Ed cannot affect the
average by collusion, sabotage, etc.)
4. Is this pay plan superior to the original plan
from a risk-sharing standpoint?
5. Devise an even better plan using the more
general form:
C � a � 0.2(own sales � � average sales)
(Hint: Remember to adjust the intercept to keep expected compensation the same.)
6. Calculate the average pay and standard
deviation for this plan.
chapter
17 C H A P T E R O U T L I N E
Measuring Divisional Performance
Cost Centers
Expense Centers
Revenue Centers
Profit Centers
Investment Centers
Transfer Pricing
Economics of Transfer Pricing
Common Transfer- Pricing Methods
Reorganization: The Solution If All Else Fails
Internal Accounting System and Performance Evaluation
Uses of the Accounting System
Trade-offs between Decision Management and Decision Control
Summary
B riggs & Stratton with 2013 sales of $1.9 billion is the world’s largest producer of gasoline engines for outdoor power equip- ment.1 B&S engines, primarily 3–25 horsepower, are purchased by original equipment manufacturers and incorporated into lawn
and garden equipment such as mowers and garden tillers. In the 1980s, most of their manufacturing plants were unionized. Union work rules limited B&S’s labor productivity, causing B&S’s labor costs to exceed those of their competitors. To reduce their labor costs, B&S invested heavily in automa- tion. While automation was consuming B&S’s capital, competition (primar- ily from Japan) was reducing their profits. Moreover, a shift from indepen- dent dealers to mass merchandisers, such as Walmart, Kmart, and Home Depot, who insisted on price concessions from their suppliers, put further pressure on B&S’s profit margins. In 1989, B&S reported a $20 million loss.
Their deteriorating financial situation coupled with a changing competi- tive landscape prompted B&S to reexamine their corporate strategy, to reor- ganize the firm, and to adopt new performance measurement and compensa- tion schemes. B&S’s traditional market had been high-volume basic small engines. The firm had ventured into the high-end market, only to lose money.
Divisional Performance Evaluation
L E A R N I N G O B J E C T I V E S
1. Explain the differences between cost centers, expense centers, revenue centers, profit centers, and investment centers and when each is most appropriate.
2. Describe how return and assets and residual income provide different incentives for investment center managers.
3. Discuss the role of transfer pricing in firms. 4. Describe how the optimum transfer price changes between complete (perfect) in-
formation and asymmetric information.
5. Discuss common transfer-pricing methods and their trade-offs. 6. Explain how the internal accounting system is used to evaluate performance. 7. Discuss why internal accounting systems are more useful for managers exercis-
ing decision-control rights than for managers exercising decision-management
rights.
1Details of this example are from J. Stern and J. Shiely with I. Ross (2001), The EVA Challenge: Implementing Value-Added Change in an Organization ( John Wiley & Sons, Inc, New York), 28–33. EVA is a registered trademark of Stern Stewart. www.briggsandstratton.com.
538 Part 3 Designing Organizational Architecture
Briggs & Stratton refocused its strategy back to its core business to become the low-cost high-volume producer. To implement this strategy in the 1980s and to boost sales to the mass merchandisers, B&S had to economize on both capital and labor costs. This required a reassignment of decision rights. B&S had been func- tionally organized. This worked well when the engines were relatively simple and its environment was reasonably stable. But engines were becoming more complex and its operating environment more volatile. B&S reorganized around major prod- ucts (the small-engine division for walk-behind mowers, large-engine division for ride-on mowers, aluminum castings division, and iron castings division). Decision rights were decentralized to product managers, who were held responsible for oper- ating decisions and capital expenditures. Furthermore, to focus managers’ atten- tion on both operating and capital costs, the performance evaluation and reward systems were altered.
Briggs & Stratton changed the way performance was evaluated when it adopted Economic Value Added (EVA) in 1990. EVA is the after-tax operating profit of the division minus the total annual opportunity cost of the capital invested in the divi- sion. The total annual cost of capital is the product of the division’s cost of capital times the amount of capital invested in the division. Thus, managers in the newly or- ganized divisions became responsible for how much capital they were using. More- over, they were given incentives to increase EVA (by increasing sales or by decreas- ing operating or capital costs) because 40 percent of their bonuses were based on corporate EVA, 40 percent on divisional EVA, and 20 percent on appraisal of per- sonal performance by their superior.
These changes in organizational architecture—the new strategic focus, decentral- ization, and tying bonuses to EVA—had a dramatic effect. In 1989, before adopting EVA, B&S’s EVA was negative $62 million. This means that its operating earnings fell short of covering its cost of capital by $62 million. By 1993, Briggs & Stratton showed a positive EVA, and it generated positive EVA from 1993 through 2000, in- cluding a record EVA of $50.9 million in 1999. The stock market recognized this performance and B&S’s stock price rose from about $6 per share in the fall of 1990 to about $20 in 2000. Most of B&S’s stock price increase occurred in the first four years after changing its strategy and organizational architecture. Between 1995 and 2005, B&S’s stock price has tracked the broader market indexes, but since 2005 B&S’s stock price has under performed the market. It is interesting to note that con- sistent with Figure 11.1, Briggs & Stratton adopted an integrated approach to orga- nizational change, which involved matching a new strategy with a revised organiza- tional architecture: decentralization of decision rights, EVA performance measure, and tying pay to EVA.
In Chapter 16, we described individual performance-evaluation systems. Our dis- cussion is extended in this chapter to evaluating the performance of business units within the firm. Firms are organized in a variety of ways: By function, by product line, or by geography. Most organizations partition decision rights among subunits within the firm. Managers of these subunits are then rewarded based on the performance of their unit. In other words, the subunit’s performance metric is used to measure and then reward that subunit’s managers’ performance. This chapter describes different ways organizations measure the performance of their various business units. The next section describes commonly used arrangements—cost centers, expense centers, rev- enue centers, profit centers, and investment centers. These subunits are assigned dif- ferent sets of decision rights and accordingly use different performance-evaluation metrics—for instance, costs, revenues, profits, or EVA. Because business units within
Chapter 17 Divisional Performance Evaluation 539
the organization interact with one another and often exchange goods or services among themselves, reported performance of each center involved in an exchange de- pends on the rules used to value the exchange. Performance evaluation of business units exchanging goods or services requires establishing an internal transfer price for these exchanges. The following section discusses these transfer-pricing issues. Finally, because most firms rely on their accounting systems to measure the performance of their business units, we discuss general issues involving use of the accounting system in measuring performance.
Measuring Divisional Performance2
All but the smallest organizations invariably are divided into subunits, each granted particular decision rights and then evaluated based on performance objectives for that subunit. Rewards typically are based on these performance evaluations. In effective organizations, performance-evaluation and reward systems are consistent with the de- cision rights granted the unit manager—the three legs of the stool are balanced. Chapter 13 described alternative organizational structures: U form, M form, and ma- trix organizations. In the U form, one unit might be responsible for manufacturing, an- other for R&D, another for marketing, and so forth. These basic building blocks of the organization are the work groups that define what each part of the firm does. Senior management attempts to evaluate the performance of these various subunits both for setting rewards for lower-level managers as well as for making business decisions— for instance, which businesses to expand.
Teams often are more productive than individuals working independently. The business units of the organization are, in effect, large production teams. For example, the maintenance department maintains facilities; the marketing group structures and implements marketing plans; research and development explores potential new prod- ucts; support groups provide products and services to customers. Each unit generally can be characterized into one of five categories based on the decision rights it has been granted and the way its performance is evaluated: Cost centers, expense centers, revenue centers, profit centers, and investment centers. For instance, Briggs & Stratton changed from evaluating some of its divisions as cost or profit centers to evaluating them as investment centers.
Cost Centers
Cost centers are assigned the decision rights to produce a stipulated level of output; in achieving this objective, the unit’s efficiency is measured and rewarded. Cost cen- ter managers are granted decision rights for determining the mix of inputs—labor, materials, and outside services—used to produce the output. Managers of cost cen- ters are evaluated on their efficiency in applying these inputs to produce output. Since they are not responsible for selling their output, they are not judged on rev- enues or profits.
To evaluate the performance of a cost center, its output must be measurable. Moreover, because it retains the decision rights to specify the department’s output or
2This section draws on M. Jensen and W. Meckling (1998), “Divisional Performance Measurement,” in M.
Jensen (Ed.), Foundations of Organizational Strategy (Harvard University Press: Cambridge), 345–361.
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budget, central management must possess the requisite specialized knowledge. Manufacturing departments, like the welder assembly department at Lincoln Electric, normally are cost centers. The output of the welder assembly department is measured by counting the number of welders completed. Besides manufacturing set- tings, cost centers also are used in service organizations such as a railroad’s railcar maintenance department (where output is measured as the number of railcars serviced), transaction processing by a bank (number of transactions processed), or food services in a hospital (number of meals served). In addition to measuring the quantity of output, its quality must be monitored effectively. If not, unit managers evaluated on costs have incentives to meet their targets by cutting quality. Thus, Lincoln Electric must have mechanisms to ensure that assembled welders meet qual- ity standards, which requires that quality must be reasonably observable.
Various objectives are used for evaluating cost center performance. Two of the more widely used are
• Minimize costs for a given output.
• Maximize output for a given budget.
In order to maximize value, managers must select the optimal output Q * and pro- duce this output at minimum cost. Cost center managers focus primarily on the sec- ond of these activities—cost minimization. Their task is to choose the efficient input mix. For example, if Anthony Mancuso, the manager of the railcar maintenance de- partment, is told to service 100 railcars per day, he is evaluated on meeting this pro- duction schedule and controlling the cost of servicing the railcars. The quantity de- cision tends to be made by central management. The first potential evaluation criterion focuses directly on cost minimization. Minimizing costs given a prespecified quantity (and quality) is consistent with value maximization, so long as the appro- priate quantity, Q*, is selected as the target output.
The second potential evaluation criterion, maximizing output for a specified budget, provides incentives equivalent to the first criterion, given that the specified budget is the minimal budget necessary for producing Q*. For example, Tony might
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VA Administrators Game Their Performance Measures The Secretary of the U.S. Department Veterans Affairs, General Eric Shinseki, was forced to resign following the
disclosure of secret waiting lists at several V.A. hospitals serving former U.S. military personnel, many of whom were
wounded in action. Administrators at veterans’ hospitals were told to alter data to make patient-access numbers look
good for their supervisors. These superiors did not want long reported wait times because their bonuses are tied
directly to the waiting times of the veterans. Reporting long wait times produced unfavorable performance reviews, and
hence a lower bonus. In one hospital, many veterans were not entered into the official electronic waiting list, thereby
distorting actual delays in providing care. Another V.A. clinic changed its bonus system whereby 20 percent of
physician performance pay would be paid only to doctors who limited patient follow-up visits to an average of two a
year, as a way to reduce waiting times by persuading veterans to make fewer appointments.
This example illustrates (again) that pay for performance creates incentives to game the system. In other words,
employees will attempt to game all performance measures, especially when they are used to determine rewards. The
critical managerial question is: “By how much?”
Source: R. Oppel and A. Goodnough (2014), “Doctor Shortage Is Cited in Delays at V.A. Hospitals,” NY Times ( May 29).
Chapter 17 Divisional Performance Evaluation 541
be given a fixed budget ($27,500 per week) and evaluated based on the number of railcars serviced that meet quality specifications within his fixed budget. In either case, Tony has incentives to select the cost-minimizing input mix for producing Q *.
For both objectives, the manager is constrained either by total output or by the bud- get. Effective implementation requires that central management choose either the value-maximizing output level or the appropriate budget for efficient production of this output level. Nonetheless under either cost center arrangement, Tony has incen- tives to reduce costs (or increase output) by lowering quality—hence, the quality of production in cost centers must be monitored.
Cost center managers sometimes are evaluated based on minimizing average cost. In this case, the manager has the incentive to choose the output at which aver- age costs are minimized and to produce this output efficiently. It is important to un- derstand that value maximization need not occur at the point where average costs are minimized. In general, minimizing average unit cost is not the same as maxi- mizing value. For example, in Table 17.1, profits are maximized by selling 6 units; yet, average cost is minimized by producing 9 units. Maximum profits occur where marginal costs and marginal revenues are equal—this need not be where average unit costs are lowest. As another example, suppose a cost center has fixed costs in addition to constant marginal costs. Then average unit costs fall with increases in output. To illustrate, assume that total costs are
TC � $6Q � $300,000 (17.1)
Fixed costs are $300,000, and marginal costs are a constant $6 per unit. Given the equation for total costs, average costs are derived by dividing both sides of the equa- tion by Q to get
(17.2)AC � TC
Q � $6 �
$300,000
Q
Quantity Price ($) Revenue ($) Total Cost ($) Total Profits ($) Average Cost ($)
1 35 35 78 �43 78.0 2 33 66 83 �17 41.5
3 31 93 90 3 30.0 4 29 116 99 17 24.8 5 27 135 110 25 22.0 6 25 150 123 27 20.5 7 23 161 138 23 19.7 8 21 168 155 13 19.4 9 19 171 174 �3 19.3
10 17 170 195 �25 19.5
Table 17.1 Example Demonstrating That Minimizing Average Cost Does Not Yield the Profit-Maximizing Level of Sales
Minimizing average unit cost is not the same as maximizing profits. Maximum profits occur where marginal costs and marginal revenues are equal, which need not be where average unit costs are lowest. In this simple example, profits are maximized by selling 6 units. However, minimum average cost occurs by producing 9 units.
542 Part 3 Designing Organizational Architecture
With constant marginal cost, as quantity produced increases, AC falls. In this situation, a cost center manager who is evaluated based on average unit costs has incentives to in- crease output, even as inventories mount. Focusing on average costs can provide incen- tives for cost center managers to either overproduce or underproduce; it will depend on how the value-maximizing output level compares to the quantity where average costs are minimized.
Cost centers work most effectively when central managers have a good under- standing of the business unit’s cost structure, can determine the value-maximizing output level, can monitor quantity as well as quality, and can establish appropriate re- wards; in addition, the cost center manager has specific knowledge of the optimal input mix.
Expense Centers
Cost centers are a common way of organizing manufacturing units. However, activ- ities such as personnel, accounting, patenting, public relations, and research and de- velopment often are organized as expense centers. As in cost centers, expense center managers are given fixed budgets and asked to maximize service/output. The funda- mental difference between expense centers and traditional cost centers is that output in expense centers is measured more subjectively than objectively. Thus, an expense center is basically a cost center that does not produce an easily measurable output.
The difficulty in observing the output of an expense center has several implica- tions. As director of human resources, Salman Abassi is given a total budget and told to provide as much service as possible. Because the cost per unit of output is difficult to measure, the users of this expense center typically are not charged directly for the center’s services.3 Hence, his users tend to overconsume the services, and Salman regularly requests larger budgets. The central corporate budget-setting organization has difficulty determining the budget that maximizes the firm’s value, again because output is not easily observed. Expense center managers frequently derive additional benefits from managing larger staffs (empire building), which reinforces the ten- dency of these centers to grow faster than the firm as a whole. If the central budget office tries to cut the human resource department’s budget, Salman might threaten to reduce those services that are most highly valued by users to enlist their help lobby- ing against the proposed budget cuts. This behavior is yet another example of influence costs.
A number of devices are employed to control expense centers. One is to bench- mark their budgets against those of comparable centers in similar-sized firms. An- other is to reorganize the firm and place the expense center under the control of their largest user, who then not only has more specialized knowledge of the expense cen- ter’s value but also has been delegated the decision rights to set the expense center’s budget. Yet, this reorganized structure frequently supplies too little of the service to other units. If these other users are charged more than marginal cost, they demand too little of the services. Alternatively, without a charge-back system for the expense center’s services, the controlling user might ration resources provided to other busi- ness units and again other users would receive too little of its services.
3In some cases, firms indirectly charge for these services through a cost allocation system. For example,
human resources does not charge for services provided; rather, other business units are charged their pro-rata
share of human resources costs based on head count.
Chapter 17 Divisional Performance Evaluation 543
Revenue Centers
To organize the marketing activities of selling, distributing, and sometimes servicing finished products received from manufacturing, revenue centers are used. The idea behind a revenue center is to compensate the manager for selling a set of products. For example, a regional sales office might be evaluated as a revenue center. The re- gional sales manager, Eva Szabo, is given a budget for personnel and expenses and has decision rights as to how to deploy the budget to maximize revenue. Eva has lim- ited discretion in setting the selling price; typically, she must keep the price within a prescribed range.
As with a cost center, various objectives can be used to evaluate revenue centers. One objective is to maximize revenue for a given price (or quantity) and budget for personnel and expenses. That is, the revenue center is told the price of each product it sells and is given a fixed operating budget. This objective is consistent with value maximization so long as central management chooses the correct price-budget com- bination for each product sold by the revenue center.
Delegating decision rights to Eva over product pricing or quantity and then eval- uating her based on maximizing total revenue usually is inconsistent with value max- imization. To maximize revenue, Eva goes to the point where marginal revenue equals zero—not to where it equals marginal cost. Since marginal cost usually is greater than zero, Eva’s firm loses money on units sold at prices below marginal cost.
Revenue centers work best if sales managers have specialized knowledge of the de- mand curves of the customers within their sales district and understand how to sell products effectively while central managers understand aggregate market conditions—for instance, they need to be able to select the correct price-quantity combination as well as the optimal product mix (otherwise, salespeople might shift effort toward selling higher revenue-generating products rather than selling products that generate greater value).
Matching Decision Rights and Performance Metrics Not New In 1922, James O. McKinsey, founder of the consulting firm McKinsey & Co., described the importance of matching
the performance measure and decision rights assignment:
In the modern business organization, control is exercised through individuals who compose the organization. If control of expenses is to be affected through members of the organization, it is necessary that they be classified so as to show responsibility for each class. If responsibility is taken as the controlling factor in an expense classification, each department will be charged with those expenses over which the executive head of the department exercises control. In addition, it may be charged with some items of expense the amount of which is fixed or at least beyond the control of any officer.
To illustrate, the production department will be charged for the supplies used in production, for these supplies are under the control of the production manager, and in addition it will be charged with the depreciation on production equipment, the estimated amount of which is determined in most cases by others than the production manager.
Notice that McKinsey advocates matching the performance metric to the manager’s responsibility (i.e., decision rights).
He also argues in favor of charging not only expenses over which managers have direct control but also expenses they
control indirectly, such as depreciation.
Source: J. McKinsey (1922), Budgetary Control (New York: Ronald Press), 281.
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Profit Centers
Profit centers often are composed of several cost, and possibly expense and revenue, centers. Profit center managers are given a fixed capital budget and allocated decision rights for input mix, product mix, and selling prices (or output quantities). Profit centers are most appropriate when the knowledge required to make the product mix, quantity, pricing, and quality decisions is specific to the division and this information is costly to transfer.
Profit centers usually are evaluated on the difference between actual and budgeted accounting profits for their division. Although measuring the profits of profit centers is seemingly straightforward, two complications often consume managers’ attention: How to price transfers of goods and services between business units (transfer pric- ing) and which corporate overhead costs to allocate to specific business units. These are hotly debated topics within many firms. (We examine the transfer-pricing prob- lem in the next section.)
When there are interdependencies among business units, motivating managers of individual profit centers to maximize the profits of their business units normally fails to maximize the value of the firm as a whole. For instance, individual units focusing on their own profits frequently ignore how their actions affect sales or costs of other units.4 One division might free-ride on another division’s quality reputation, thereby reaping short-run gains at the expense of the other division and the whole firm. For example, Chevrolet and Buick are two profit centers within General Motors. Sup- pose Chevrolet, in pursuit of higher profits, decides to raise its car quality. This might affect consumers’ perceptions of the average quality of all General Motor cars— including Buick’s perceived quality. An enhanced reputation for all General Motors cars helps Buick. But if Chevrolet receives no credit for additional Buick profits, it is likely to ignore this positive externality that it generates for Buick and will tend to underinvest in quality enhancements. To help managers internalize both positive and negative externalities that their actions impose on other profit centers, firms often base incentive compensation not just on the profits of the manager’s own business unit but also on a group of related profit centers’ profits and/or firmwide profits. Un- less the group and/or the entire firm makes a certain profit target, no individual profit center manager receives a bonus. Managers at Briggs & Stratton had 40 percent of their bonus tied to corporate-wide EVA.
Investment Centers
Investment centers are similar to profit centers. However, they have additional decision rights for capital expenditures and are evaluated on measures such as return on investment. Investment centers are most appropriate where the manager of the unit has specific knowledge about investment opportunities as well as information relevant for making the unit’s operating decisions.
Several profit centers often comprise investment centers. Investment centers have all the decision rights of cost and profit centers, as well as decision rights over the amount of capital to be invested. For example, suppose Lars Erikssen manages the
4Conceptually, other units could offer side payments to take these effects into account. However, in the
presence of transaction costs, these offers are likely to be limited.
Chapter 17 Divisional Performance Evaluation 545
consumer electronics group of an electronics firm that is composed of three profit centers: The television division, the DVD division, and the stereo division. Lars has decision rights over the amount of capital invested in consumer electronics and is evaluated based on the return on the capital invested. There are two commonly used measures of performance for investment centers: Accounting return on investment and residual income (EVA).
Accounting Return on Assets The most commonly used investment center performance measure is return on assets (ROA). ROA is the ratio of accounting net income generated by the in- vestment center divided by total assets invested in the investment center. ROA has intuitive appeal because it can be compared to external market-based yields to provide a benchmark for a division’s performance.5 However, using ROA creates potential problems. ROA is not a measure of the division’s economic rate of return because neither accounting income (the numerator) is a measure of economic profit nor assets (the denominator) is the market value of the divi- sion’s assets. Economic profit is the change in value over the period. Account- ing rules tend to be conservative: They dictate that accounting net income ex- cludes some value increases and includes some value declines. For example, accounting net income excludes any appreciation in land value until the land is sold but recognizes permanent declines in market value even though the land has not been sold. Also, accounting depreciation, which is deducted from ac- counting profits, does not necessarily reflect the change in the economic value of the depreciable assets.
Lars has an incentive to reject profitable projects with ROAs below the mean ROA for the consumer electronics group because accepting these projects lowers the group’s ROA. For example, suppose the group has an average ROA of 19 per- cent, 4 percent above its 15 percent cost of capital.6 A new investment project that is 10 percent the size of the existing group total assets is available. Its ROA is 16 percent, which also is above its cost of capital of 15 percent; thus, taking this project would increase firm value. But if this project is accepted, the group’s ROA falls to 18.7 percent (.90 � 19% � .10 � 16%). If his group is evaluated based on increasing ROA, Lars will reject the project, even though its returns exceed the opportunity cost of capital.
ROA can lead to accepting unprofitable projects, too. Gail Pratt runs a division that has a 15 percent cost of capital and an average ROA of 12 percent. A new pro- ject with an ROA of 14 percent is available. Even though it has a return below her di- vision’s cost of capital, Gail is tempted to accept the project because it raises her av- erage ROA.
Riskier projects require a higher cost of capital to compensate investors for bear- ing additional risk. If managers are rewarded solely for increasing their ROA with- out being charged for any additional risk imposed on the firm, they have incentives to plunge the firm into risky projects. Finally, a manager near retirement who is evaluated based on ROA might take projects that boost ROA immediately, even if
5For firms with outstanding debt, it is important to add back interest expense to accounting income before
comparing ROA to the firm’s external market-based yields. 6Cost of capital is the rate of return the firm must pay the market to raise capital. If the firm can raise money
at 15 percent and invest in projects earning 16 percent, the value of the firm increases.
546 Part 3 Designing Organizational Architecture
they were expected to be unprofitable projects—this is just a specific case of the horizon problem.
Accounting Residual Income To overcome some of the incentive deficiencies of ROA, such as divesting projects with ROAs above their cost of capital but below the division’s average ROA, some firms use residual income to evaluate performance. Residual income measures busi- ness-unit performance by subtracting the opportunity cost of capital employed from the profits of the business unit. For example, suppose Amita Singal manages a divi- sion that has profits of $20 million (after tax but before interest expense) and total assets of $100 million. Furthermore, her division has a required cost of capital of 15 percent. Its ROA is 20 percent, which is in excess of its opportunity cost of capi- tal (15 percent). Residual income is $5 million ($20M � 15% � $100M). Although divesting a project with an ROA of less than 20 percent but above 15 percent raises average ROA, it lowers residual income. Residual income also goes by other names such as “economic profits” and “Economic Value Added (EVA).”
Nonetheless, residual income has its own problems. Residual income is an ab- solute number; thus, larger divisions typically have larger residual incomes than smaller divisions. This makes relative performance-evaluation comparisons across investment centers of different sizes more difficult. To implement residual income requires that senior managers estimate the opportunity cost of capital for each divi- sion. In principle, each division will have a different required cost of capital to allow more precise performance evaluations by controlling for risk differences. However, these risk adjustments also potentially lead to greater influence costs as divisional managers lobby to lower their required capital costs.
Like ROA, residual income measures performance over a single year. It does not measure the impact of actions taken today on a firm’s value in the future. For exam- ple, by cutting maintenance, current period residual income (and ROA) is increased, but future cash flow and hence the value of the firm might be jeopardized. Managers with short-term horizons will have incentives to avoid projects that have negative residual incomes in early years even if they are quite profitable in the long run. Thus, the use of residual income measures like EVA is not sufficient for making investment decisions.
Table 17.2 summarizes our discussion of the various types of subunits of the firm; it summarizes the measures used to evaluate performance for the different types of centers, the decision rights the various centers are granted, and circum- stances under which particular centers are used most effectively. Notice that per- formance-evaluation measures and decision-right assignments are balanced: Deci- sion rights assigned to the center and performance measures are matched. Note also the linkage between decision rights assigned to each center and the location of the specific knowledge. For example, if a center does not have knowledge of customer demand curves, it does not have decision rights for pricing and hence is evaluated as a cost center.
Although not explicit in Table 17.2, to ensure that our three-legged stool remains balanced, performance rewards must be tied to the performance evaluations. For ex- ample, besides introducing EVA in 1990, Briggs & Stratton also changed its man- agement compensation plan. B&S managers were compensated based on both their division’s EVA and firm EVA. Therefore, besides linking pay to the performance measure, EVA, B&S also changed its performance reward system.
Chapter 17 Divisional Performance Evaluation 547
Performance Decision Typically Unit Type Measures Rights Used When
Cost center Minimize total cost Input mix (labor, Central manager can measure for a fixed output material, supplies) output, knows the cost
Maximize output functions, and can set the for a fixed budget optimal quantity and
Minimize average cost appropriate rewards. Central manager can observe
the quality of the cost center’s output.
Cost center manager has knowledge of the optimal input mix.
Expense Minimize total cost Input mix (labor, Output is difficult to center for a fixed level material, supplies) observe and measure.
of services Maximize service
for a fixed budget Revenue Maximize revenues Input mix (labor, Central manager has the
center for a given price material, supplies) knowledge to select the (or quantity) and optimal product mix. operating budget
Central manager has the knowledge to select the correct price or quantity.
Revenue center managers have knowledge of the demand curves of the customers in their sales districts.
Profit center Actual profits Input mix Profit center manager has the Actual profits Product mix knowledge to select the
compared to Selling prices (or correct price/quantity. budgeted profits output quantities) Profit center manager has the
knowledge to select the optimal product mix.
Investment Return on Input mix Investment center manager center investment Product mix has the knowledge to select
Residual income Selling prices (or the correct price/quantity.
EVA output quantities) Investment center manager
Capital invested in has the knowledge
center to select the optimal product mix.
Investment center manager has knowledge about investment opportunities.
Table 17.2 Summary of Cost, Expense, Revenue, Profit, and Investment Centers
Performance measures and decision rights are balanced across the various subunits of the organization. Their use depends on the distribution of specific knowledge.
548 Part 3 Designing Organizational Architecture
M A N A G E R I A L A P P L I C AT I O N S
Boosting Return on Capital Eaton, a maker of transmissions for large trucks, divided its different transmission components into three categories:
Those for which other firms were more cost-effective because they had economies of scale, those for which Eaton was
the most efficient producer or for which it had proprietary technology, and all other component parts of its
transmissions. Eaton then outsourced the manufacturing of all component parts other than those for which it was the
most efficient producer or for which it had proprietary technology. By doing this, Eaton significantly dropped the asset
intensity of its business, thereby leading to better returns on capital.
Source: D. Katz (2010), “Lite Makes Right,” CFO (November), 35–36.
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EVA Often Is Linked to a Change in the Compensation Plan At the beginning of this chapter, Briggs & Stratton’s use of economic value added was described as a performance
measurement plan that is being widely heralded and adopted by such companies as AT&T, CSX, Coca-Cola, Equifax,
and Quaker Oats. EVA is a variant of residual income. The formula for EVA is
EVA � adjusted accounting earnings � (weighted average cost of capital � total capital)
This is the same formula as residual income, but variables used in computing EVA are measured more carefully than
historically has been done. Instead of using the same accounting procedures that are used in reporting to shareholders,
different accounting procedures are used to arrive at “adjusted accounting earnings.” For example, standard U.S.
accounting rules require that the entire amount spent on research and development each year be deducted from
earnings. This creates incentives for managers with a short time horizon to cut R&D spending. One adjustment to
accounting earnings some EVA adopters make is to add back R&D spending and treat it as an asset to be amortized,
usually over five years. Total capital, in the above formula, consists of all the firm’s assets, including the amount
invested in R&D and other adjustments made to earnings.
EVA uses a weighted average cost of capital, which reflects the cost of equity and debt. The cost of equity is the
price appreciation and dividends the shareholders could have earned in a portfolio of companies of similar risk. This is
the opportunity cost the shareholders bear by buying the company’s stock. The cost of debt is the current market yield
on debt of similar risk. The costs of debt and equity are weighted by the relative amounts of debt and equity. Suppose
the cost of equity is 18 percent, the cost of debt is 10 percent, and the firm’s capital structure is 40 percent debt and
60 percent equity. Then, the weighted average cost of capital is 14.8 percent (0.60 � 18% � 0.40 � 10%).*
EVA, like residual income, measures the total return after deducting the cost of all capital employed by the firm. It
estimates the economic profits of the firm in the period (usually a year). Many of the firms adopting EVA to measure
divisional performance did so as part of a corporate reorganization. Besides rewarding the CEO and other top
managers based on EVA, many firms measure and then reward each of their divisional managers based on the
division’s EVA. Besides decentralizing decision rights and adopting EVA as the performance measure, firms also
change the third leg of the three-legged stool, the reward system. Manager bonuses are based on EVA.
*EVA is calculated on an after-tax basis using adjusted accounting earnings before interest but net of income taxes. The weighted
average cost of capital is computed as follows. The after-tax cost of debt is computed using 1 minus the marginal corporate tax rate
times the market yield on debt of similar risk. For example, suppose the market yield on equivalent debt is 15 percent and the marginal
corporate tax rate is 38 percent. The after-tax cost of debt is 9.3 percent [15% � (1 � 0.38)]. If the cost of equity is 20 percent and the
proportions of debt and equity are the same, the after-tax weighted average cost of capital is 14.65 percent (0.50 � 9.3% � 0.50 �
20%).
Source: B. Stewart (2013), Best-Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value (John Wiley & Sons: Hoboken).
Chapter 17 Divisional Performance Evaluation 549
Transfer Pricing7
As discussed earlier, firms organize into business units. Whenever business units transfer goods or services among themselves, measuring their performance requires that a transfer price be established for the goods and services exchanged. For example, recall that Briggs & Stratton reorganized and created several investment centers including the aluminum castings and small-engines divisions. Besides producing for and selling to outside customers, the aluminum castings division also sells intermediate products to other investment centers within B&S. In order to mea- sure the performance of these investment centers, each of these internal transactions requires a transfer price. The purchasing division pays the transfer price; the produc- ing division receives the transfer price.
Some executives do not view the transfer-pricing problem as important from the overall firm’s perspective. They think that changing transfer-pricing methods merely shifts income among divisions and that, except for relative performance evaluation, little else is affected. But this is a mistake: The choice of transfer-pricing method does not merely reallocate total company profits among business units, but affects the firm’s total profits. Think of the firm’s total profit as a pie. Choice among trans- fer-pricing methods not only changes how the pie is divided among the business units, but also changes the size of the pie to be divided.
Managers make investment, purchasing, and production decisions based on the transfer prices they face. If from the firm’s perspective these transfer prices do not re- flect resource values accurately, the value of the firm will be reduced because man- agers will make inappropriate decisions. For example, if the opportunity cost to B&S of producing an aluminum casting is $20 but the transfer price is $30, the small-en- gines division will buy too few castings and firm value will be reduced. Purchasing division managers will have the incentive to shift away from the aluminum castings, perhaps outsourcing that purchase even though, in reality, outsourcing is more ex- pensive. Also, because transfer prices affect managers’ performance evaluations, in- correct transfer prices can result in inappropriate promotion and retention decisions.
Transfer prices are more prevalent in organizations than many managers realize. Firms often have extensive charge-back systems for internal service departments. Con- sider the charges that the advertising department receives from the maintenance de- partment for janitorial service, as well as charges for telephones, security services, data processing, legal, or human resource services. Most firms charge inside users for these internally provided services. Such charge-back systems also exist in hospi- tals, universities, and other nonprofit organizations. These charge-back systems are internal transfer prices.
Because the use of transfer prices (including charge-back systems) is widespread and because transfer pricing affects performance evaluation and hence the rewards managers receive, fighting over the transfer price between divisions is virtually in- evitable. Transfer pricing is a continuing source of tension within firms. Many man- agers in multidivisional firms are involved in a parade of transfer-pricing disputes over the course of their careers.
A potentially important factor in determining an optimal transfer price is taxes. If the producing and purchasing divisions are in different countries and subject to differ- ent tax rates, then taxes affect the opportunity cost of the product and thus the optimal
7This section draws on J. Brickley, C. Smith, and J. Zimmerman (1995), “Transfer Pricing and the Control of
Internal Corporate Transactions,” Journal of Applied Corporate Finance 8, 60–67.
550 Part 3 Designing Organizational Architecture
transfer price. The producing division pays income taxes on the difference between its costs and what it receives for each unit, which is determined by the transfer price. In general, to minimize the sum of the two taxes, the firm should set the transfer price so as to allocate as much of the profit as possible to the division in the country with the lower tax rate.8 To simplify the analysis, this section focuses on the organizational eco- nomics of transfer pricing and ignores these potentially important tax issues.
Economics of Transfer Pricing
The optimal transfer-pricing rule is quite simple to state: The optimal transfer price for a product or service is its opportunity cost—it is the value forgone by not using the product transferred in its next best alternative use. Unfortunately, as we will see, this rule, although simple to state, often is difficult to implement in practice.
8International tax treaties and local regulation constrain the transfer-pricing methods firms can use for tax
purposes. See M. Scholes, M. Wolfson, M. Erickson, E. Maydew, and T. Shevlin (2009), Taxes and Business Strategy: A Planning Approach, 4th edition (Prentice Hall: Englewood Cliffs).
M A N A G E R I A L A P P L I C AT I O N S
Transfer Pricing and Taxes By some estimates, aggressive transfer pricing by U.S. companies cost the Federal treasury up to $60 billion per year.
The Federal government closely monitors these firms’ tax returns and often challenges what it deems to be improper
transfer-pricing mechanisms. U.K.-based GlaxoSmithKline (GSK) agreed to settle its transfer-pricing dispute with the
U.S. IRS by paying $3.1 billion. The government’s original claim against GSK was for $11.5 billion for 16 years
between 1989 and 2005. The dispute involved how GSK treated as part of the transfer price of making its popular ulcer
drug Zantac the marketing expenses and R&D costs. In the United States, 30 percent of all corporate tax adjustments
made each year involve transfer-pricing disputes.
Apple Inc. reduced its 2011 federal tax bill by billions of dollars. Apple conducts most of its research in the United
States. Most of its key employees, long-lived assets, and retail stores are in the United States. But by employing legal
transfer-pricing rules, Apple reports only 30 percent of its profits as being from the United States, which imposes one
of the highest tax rates on corporate earnings (35 percent). However, some estimates place Apple’s actual worldwide
effective tax rate closer to 13 percent.
One pharmaceutical maker, Forest Laboratories, cut its tax bill by a third. Forest, headquartered in New York City,
manufactures the drugs in Ireland, sells them primarily in the United States, and uses subsidiaries in the Netherlands
and Bermuda to recognize the income tax. Setting high transfer prices between the United States and Ireland shifts the
income first to Ireland. Then transfer prices shift the income from Ireland to the Netherlands and Bermuda, which have
even lower tax rates than Ireland. By not returning the profits to the United States in the form of cash, Forest legally
avoids most U.S. taxes on its income.
To attempt to streamline the transfer-pricing dispute-resolution process, the IRS instituted an Advanced Pricing
Agreement (APA) Program. A taxpayer team and IRS team work together prospectively to develop the transfer-pricing
method the taxpayer will use. As long as the taxpayer complies with the agreement, the IRS will not challenge
subsequent years’ transfer prices. The IRS had negotiated about 1,300 APAs by the end of 2013.
Source: IRS (2014), “Announcement and Report Concerning Advance Pricing Agreements (March 27); R. Fink (2004), “Haven or
Hell,” CFO Magazine, (March 1); M. Sullivan (2012), “Apple Reports High Rate but Saves Billions on Taxes,” Tax.com, (February 13); A. Nevius (2010), “Advance Pricing Agreements for SMEs,” Journal of Accountancy, (October), 86; and J. Drucker (2010), “Forest Laboratories’ Globe-Trotting Profits,” Bloomberg Business Week, (May 13).
Chapter 17 Divisional Performance Evaluation 551
Transfer Pricing with Costless Information To illustrate the concept of opportunity cost, we focus on two of a multinational firm’s profit centers—U.S. manufacturing and European distribution. Senior man- agement is considering making a product in the U.S. division and transferring it to its European division. Assume also that marginal cost of production is $3 per unit, and that the U.S. division has excess capacity. If the product is transferred to Europe, they can sell it and receive $5 for each unit, net of their own marginal cost. Also, everyone knows each division’s cost and revenue data.
If the unit is not manufactured, the firm saves $3 in U.S. manufacturing costs but forgoes $5 in European revenue, hence reducing profit by $2. If the unit is manufac- tured and transferred, the firm forgoes $3 (marginal cost to produce) and receives $5, for a net receipt of $2. The better alternative is to manufacture and transfer the unit. The resources forgone by transferring it from the United States to Europe—and hence the opportunity cost of such a transfer—are $3 per unit, the same as U.S. man- ufacturing’s marginal cost of production.
As this example is meant to suggest, the marginal cost of producing the unit often is its opportunity cost. But this is not always the case. Sometimes, the op- portunity cost is the marginal revenue of selling the intermediate good externally. For example, suppose the U.S. division can produce one unit for $3, and can ei- ther transfer that unit to Europe or sell it for $6 in the United States, but, because of limited capacity, it cannot do both. In this case, by having the U.S. division trans- fer the unit to Europe, the firm forgoes selling the intermediate good in the U.S. mar- ket. And even though the marginal cost of producing the unit still is $3, the opportu- nity cost of making the transfer now is $6. Thus, it now is optimal to sell it externally rather than to transfer it to Europe.
More generally, the U.S. division will produce to the point where the marginal cost of the last unit equals the transfer price. Likewise, the European division will buy units from the U.S. division so long as their net receipts just cover the transfer price. When opportunity cost is used to set the transfer price and both divisions are maximizing their respective profits, total firm profits are maximized, assuming
M A N A G E R I A L A P P L I C AT I O N S
Dual Transfer-Pricing Systems? Some consultants advocate using two separate transfer-pricing systems, one aimed at satisfying tax reporting and
another directed at internal decision making. Jay Tredwell, director of CEO Solutions for AnswerThink Consulting Group, says, “Having a separate system can give senior managers a better view of . . . real profitability [as opposed to]
their ‘tax profitability.’ ” However, Michael Patton, a partner at Ernst and Young, counters,
An essential problem with separated reporting is that transfer prices already reflect the profitability of a division or project. If you are trying to make decisions about new activities or facilities, and trying to judge their returns on invested capital, you need good benchmarks to judge these by, and good transfer prices provide part of that. Basically, then the question is whether your current transfer prices reflect economic reality or not. If they do, there’s little need for a new system. If not, the tax authorities may have a question or two for you on audit in a few years’ time.
Case Corp., a $6 billion farm and construction equipment maker, opposes separate transfer-pricing systems for
statutory and internal reporting. They argue dual systems are costly. Case keeps all accounts around the world based on
U.S. accounting practice and bases management results and compensation on actual transfer prices used by divisions
for tax purposes.
Source: I. Springsteel (1999), “Separate but Unequal,” CFO (August), 89–91; and C. Choe and C. Hyde (2007), “Multinational Trans- fer Pricing, Tax Arbitrage and the Arm’s Length Principle,” Economic Record (December), 398–404.
552 Part 3 Designing Organizational Architecture
no other interdependencies between the divisions (we consider the case of dependencies among divisions later). Thus, in this simple example, the transfer price represents the marginal cost to the European division. If the transfer price is too high or too low relative to opportunity cost, Europe purchases either too few or too many units and the firm’s profits thus are lower.
Transfer Pricing with Asymmetric Information The preceding discussion assumes that everyone knows the U.S. division’s marginal production cost, the intermediate product’s external price, Europe’s marginal revenue, and whether the U.S. division has excess capacity. Yet if all this knowledge were read- ily available, there would be no reason to decentralize decision making within the or- ganization. Central management would have the knowledge to make the decision and could retain the decision rights or, if the decision rights were delegated, closely mon- itor the process at low cost. In reality, much of this information is not readily available to central management. Especially in large, multidivisional firms, such knowledge generally resides at lower levels within the firm. There, it is private knowledge, costly to either transfer or verify by senior management. In some circumstances, lower-level managers have incentives to distort the information they pass to senior managers. To illustrate these incentives, we consider a firm with market power.
Consider the situation where Hiroshi Komada, the manager of manufacturing, is the only person with detailed knowledge of his division’s marginal costs, and assume that Hiroshi seeks to maximize the profits of his division. Even if distribution is allowed to purchase the product on the outside, if manufacturing has market power in setting the transfer price, it will attempt to set the price above marginal cost to in- crease its measured profits. When this happens, the firm manufactures and sells too few units of the product. This is another example of unexploited gains from trade from monopoly. The manufacturing division possesses what amounts to monopoly rights in information and hence behaves like a monopolist. Just as monopolists earn “monopoly profits” by raising prices and restricting output, manufacturing’s higher profits lead to lower-than-optimal production levels and reduced total firm value.
As a simple illustration of this, consider a firm that produces one product and faces the following demand:
P � 110 � 5Q (17.3)
Assume that the product is produced at a constant marginal cost of $10. Profit maximization occurs by setting marginal revenue equal to marginal cost. At this condition, Q* � 10 and P* � 60. Firm profits are $500 ($60 � 10 � $10 � 10). Figure 17.1 depicts this situation.
Assume that manufacturing produces the good at MC � 10 and transfers it to distribution at a transfer price, Pt. Suppose the only cost to the distribution division is the transfer price. (For simplicity, additional distribution costs equal zero.)
Distribution sells the product externally and thus the demand curve for its product is the firm’s demand curve. How many units of the good will the manager of this unit want to buy at each possible transfer price? Note that distribution’s marginal cost is the transfer price MCd � Pt . Distribution maximizes division profit by setting MCd � MRd. Hence, in this case, the firm’s marginal revenue curve represents distri- bution’s demand for the good and thus is the derived demand curve facing manufac- turing: Pt � 110 � 10Q (the marginal revenue curve in Figure 17.1).
Next, assume that manufacturing sets the transfer price. It has monopoly power, and because of costly information, senior management cannot monitor the decision.
Chapter 17 Divisional Performance Evaluation 553
What price will manufacturing set and what quantity of the good will be produced? Hiroshi has one customer, the distribution division. To maximize his profits in manu- facturing Hiroshi sets MCm � MRm. His marginal cost is $10. What is Hiroshi’s mar- ginal revenue? To answer that question we must look at his customer, the distribution division. Distribution has market power and faces the demand curve: P � 110 � 5Q. The distribution division’s marginal cost is the transfer price: MCd � transfer price. Distribution will take the transfer price and set it equal to its marginal revenue, in this case MRd � 110 � 10Q. This marginal revenue curve for distribution displays how Hiroshi’s customer (the distribution division) alters demand as Hiroshi varies the trans- fer price and hence his customer’s marginal cost. For example, if Hiroshi sets the transfer price at $50, distribution will maximize its profits by setting MCd � MRd. Or,
$
60
110
P ri
ce (
in d
o lla
rs )
Q 2210
Firm profit = $500
MC = $10
MR
Quantity
D
Figure 17.1 Profit-Maximizing Price
A firm faces the following demand curve: P � 110 � 5Q. The product is produced at a constant marginal cost of $10. Profit maximization occurs by setting marginal revenue equal to marginal cost. At this condition, Q* � 10 and P* � 60. Firm profits are $500 ($60 � 10 � $10 � 10).
ANALYZING MANAGERIAL DECISIONS: The Copper Box Company
You have been hired as a consultant to the CEO of
the Copper Box Company. This company holds
two patents, one for the technology for making the
copper boxes and the other for a copper box design.
The patent production technology belongs to the
manufacturing division and the unique patented
copper box design is sold by the distribution divi-
sion. Distribution buys the boxes from manufactur-
ing, and both divisions are run as profit centers.
Manufacturing sells some of the copper boxes to
outside firms, but outsiders cannot buy the patented
copper boxes from manufacturing directly. These
boxes are only available through the distribution
division. Further assume that manufacturing has
enough capacity to sell both internally and exter-
nally. Thus, the opportunity cost of manufactur-
ing’s transfer is its marginal production cost.
The CEO of the Copper Box Company believes
strongly in decentralization and the principle that
the two division managers should be free to set
the prices of their own products, including the
right of manufacturing to set the price that distrib-
ution pays for the boxes produced by manufactur-
ing. Write a memo to the CEO explaining why
such a policy fails to maximize the value of the
Copper Box Company.
554 Part 3 Designing Organizational Architecture
$50 � 110 � 10Q. Solving for Q * � 6 units. Therefore, if Hiroshi sets the transfer price at $50, distribution will buy 6 units. The important point to understand is that the demand curve Hiroshi faces is distribution’s marginal revenue curve. The demand curve facing Hiroshi is not the firm’s (or distribution’s) demand curve but rather it is the firm’s marginal revenue curve. Thus, manufacturing faces a derived demand curve equal to the marginal revenue curve for the firm: P � 110 � 10Q. Using this as his de- mand curve, Hiroshi’s marginal revenue curve is MRm � 110 � 20Q. To maximize his division’s profits Hiroshi sets MRm � MCm. Or, 110 � 20Q � $10 and sells 5 units to distribution at a transfer price of $60 (transfer price � P � 110 � 10 � 5). (See the left panel in Figure 17.2.) Facing a transfer price of $60, distribution in turn will sell the 5 units to the external market at a price of $85 (right panel in Figure 17.2). Total firm profits are $375 (5 � $85 � 5 � $10), which are lower than at the firm’s profit- maximizing output of 10 units—$500. Manufacturing reports profits of $250, and distribution books profits of $125. Both divisions are reporting profits, but total firm profits are lower in Figure 17.2 than in Figure 17.1.
The basic problem is that distribution, facing a transfer price of $60, overesti- mates the opportunity cost to the firm of producing extra units of the good (which is $10). Hence, from the firm’s standpoint, distribution stops short of the optimal quan- tity to be sold to the external market. The transfer price that ensures firm profit max- imization in this example is the marginal production cost of the unit. Note, however,
MC
MC
5
Quantity Quantity
5 11 2211 Q Q
$ $
110
60
110
60
85
10
Profits = $250
Manufacturing division
Profits = $125
Distribution division
MR D DMR
C
o st
s (i n d
o lla
rs )
Figure 17.2 Decentralized Firm
In the decentralized firm, manufacturing produces the good at MC � 10 and transfers it to distribution at a transfer price, Pt. Distribution’s demand curve for the product is the firm’s demand curve. Distribution’s marginal cost is the transfer price MCd � Pt. Distribution maximizes profit (for the unit) by setting MCd � MRd. The firm’s marginal revenue curve represents distribution’s demand for the good and is, therefore, the demand curve facing manufacturing: Pt � 110 � 10Q. The manager of manufacturing sets marginal cost equal to marginal revenue: MCm � MRm. The marginal cost � 10. The marginal revenue for the manufacturing division is Pt � 110 � 20Q. Profit maximization for manufacturing will involve setting the transfer price at $60 and selling 5 units of the good (see the left panel). Facing a transfer price of $60, distribution will in turn sell the 5 units to the external market at a price of $85 (right panel). Total firm profits are $375 (5 � $85 � 5 � $10), which are lower than at the firm profit-maximizing output of 10 units ($500). Manufacturing has profits of $250, and distribution has profits of $125.
Chapter 17 Divisional Performance Evaluation 555
that Hiroshi does not want to set $10 as the transfer price because manufacturing would report a lower profit—in this example, $0.
The earlier discussion thus illustrates the basic incentive problems associated with internal transfers when information is held privately by divisional managers. Oppor- tunity cost is the transfer price that maximizes a firm’s value. But because business- unit managers tend to have better knowledge of opportunity costs than senior man- agement and because transfer prices frequently affect performance evaluation and managerial rewards, divisional managers have incentives to distort information to in- fluence the transfer price.
Complicating matters further, getting the information necessary to calculate op- portunity costs is especially difficult for senior management because opportunity costs depend on the firm’s next best alternative use of the good or service. Central management is likely to know less about the next best use of a product, and about the resources used to make the product, than the manager of the division that produces it. Moreover, the next best alternative will change as the firm’s business opportuni- ties change. For example, sometimes the division has excess capacity and manufac- turing can sell the good both internally and externally. At other times, manufacturing has only enough current capacity to produce for either the inside or outside user. This specialized knowledge of the alternatives is held primarily by the division managers.
Problems arise whether distribution or manufacturing has the decision rights to set the price of the goods or services transferred and the other division cannot pur- chase or sell outside. Manufacturing sets a price above opportunity cost to capture some monopoly profits, and distribution purchases fewer units than if the appropri- ate (lower) transfer price were set. But, if given the decision rights to determine the price, distribution would set a transfer price below the opportunity cost and manufac- turing would supply too few units. Again, the number of units transferred is below the profit-maximizing level. If central management knew the opportunity cost, it would not have to decentralize decision making to the profit centers and could dictate both price and quantity decisions.
ANALYZING MANAGERIAL DECISIONS: HiTek Bikes
You work for HiTek Bikes that designs and manu-
factures a high performance road bike frame, the
Dura Carbon Ace. The demand curve for this
frame is given by P � $6,600 � 10Q, where Q is the number of frames sold and P is the price. The total cost of production is TC � Q 2. Given this total cost curve, we know that marginal cost is
MC � 2Q.
1. Verify numerically that when TC � Q 2 mar- ginal cost is MC � 2Q.
2. What are the optimal output, price, and profits
for the firm?
3. Now assume that the firm is divided into two
profit centers. One division manufactures the
product at a total cost of TC � Q 2 and then transfers it to a selling division that faces the
firm’s demand curve. The selling division has
no other costs other than the transfer price for
the product. Assume that the manufacturing
division has the power to set the transfer
price and that the selling division can only
buy internally. The selling division, however,
can select the quantity to purchase. What
transfer price will the manufacturing unit
select? What are the resulting profits of the
two units?
4. From the firm’s standpoint, what is the optimal
transfer price?
556 Part 3 Designing Organizational Architecture
The economics of transfer pricing is summarized well by the following quote:
The economist’s first instinct is to set the transfer price equal to marginal cost. But it may be difficult to find out marginal cost. As a practical matter, marginal cost infor- mation is rarely known to anybody in the firm, because it depends on opportunity costs that vary with capacity use. And even if marginal cost information were available, there is no guarantee that it would be revealed in a truthful fashion for the purpose of determining an optimal transfer price.9
Common Transfer-Pricing Methods
The correct transfer price, then, is opportunity cost. But, determining opportunity costs is expensive—in part because the information necessary to calculate such costs resides with operating managers who have incentives to distort it. To address this problem, companies sometimes commission special studies of the firm’s cost structure by outside experts. Such studies, however, are not only costly, but their findings become outdated whenever the firm’s business opportunities or productive capacities change. If senior management simply vests the right to set the transfer price with either manufacturing or distribution, prices are likely to be set too high or too low, resulting in too few units transferred and the firm’s value lower than it could be.
Because determining opportunity costs is itself an expensive undertaking, man- agers resort to various lower-cost approximations. There are at least four different methods for setting transfer prices that firms regularly use to approximate the op- portunity cost of the units transferred: market price, marginal production cost, full cost, and negotiated pricing. As discussed below, each of these four methods is bet- ter than the others in some situations, but not in others. For example, if the divisions operate in different countries with different tax rates, then the choice of method will be driven in part by tax considerations. If manufacturing faces lower tax rates than distribution, full-cost prices will allocate more of the profit to the lower-taxed divi- sion than marginal-cost prices. In the remainder of this section we describe the vari- ous methods and set forth their advantages and disadvantages.
Market-Based Transfer Prices The standard transfer-pricing rule offered by most textbooks is this: Given a com- petitive external market for the good, the product should be transferred at the exter- nal market price. If manufacturing cannot make a long-run profit at the external price, then the company is better off not producing internally and instead should pur- chase in the external market. If the purchasing division cannot make a long-run profit at the external price, then the company is better off not processing the intermediate product and instead should sell it in the external market.
The use of market-based transfer prices often is assumed to produce the correct make-versus-buy decisions. In many situations, however, market prices will not pro- vide an accurate reflection of opportunity costs. If the firm and the market both are making the intermediate good, the fundamental question arises, Can both survive in the long run? If one can produce the good at a lower, long-run average cost than the other, the high-cost producer should not be producing the intermediate product.
9B. Holmstrom and J. Tirole (1991), “Transfer Pricing and Organizational Form,” Journal of Law, Economics, and Organizations 7, 201–228.
Chapter 17 Divisional Performance Evaluation 557
Transactions generally take place inside rather than outside firms whenever the cost of repetitive internal contracting is cheaper than outsourcing.10 For example, production of different kinds of goods tends to take place inside the same firm when there are important interdependencies or synergies among those products. And, of course, the more valuable such synergies, the more likely the firm will continue pro- ducing internally.11
As the synergies from internal production increase, the external market price be- comes a less accurate reflection of the opportunity cost of internal production. For ex- ample, it is often the case either that an intermediate good is not being produced by other firms or that the good produced externally is not identical to the good produced internally. In one case, there is no market price; in the other, the market price often will be an unreliable guide to opportunity cost. And, even when there are virtually identical “cheaper” external products, producing internally still can make sense insofar as it provides greater quality control, more assurance of timeliness of supply, or better pro- tection of proprietary information. When these factors are included in the analysis, the external market may no longer be “cheaper.”
In such cases, use of the market price as the transfer price may understate the profitability of the product and its contribution to the value of the firm.12 Suppose, for example, an intermediate product can be purchased (but not sold) externally for $3 per unit. Synergies such as high transaction costs of using the market make it effective to produce the item internally. Internal production avoids the costs of writing and enforcing contracts. Suppose there are $.50 worth of synergies, so that the correct transfer price is $2.50 in the sense that $2.50 is the opportunity cost to the firm. But, if the market price of $3.00 is used as the transfer price, distribution will purchase fewer units than if $2.50 were used, and the value of the firm will not be maximized.
Marginal-Cost Transfer Prices If there is no external market for the intermediate good or if large synergies among business units cause the market price to be an inaccurate measure of opportunity cost, then marginal production cost may be the most effective alternative transfer price. As we saw earlier, marginal cost represents the value of the resources forgone to produce the last unit.
As with other transfer-pricing methods, there are problems with marginal produc- tion cost as a measure of opportunity cost. One is that manufacturing does not neces- sarily recover its fixed costs. If all manufacturing’s output is transferred internally and
10Advantages to internal transactions include the elimination of credit risk, lower marketing costs, and
learning from production. See Chapter 3 and R. Coase (1937), “The Nature of the Firm,” Economica 4, 386–405. For a summary of the arguments for the types of costs that are lowered by firms, see R. Watts
(1992), “Accounting Choice Theory and Market-Based Research in Accounting,” British Accounting Journal 24, 242–246. These arguments include economies of scale in contracting, team production and monitoring, postcontractual opportunism, and knowledge costs. Chapter 19 discusses these topics.
11Interdependencies or synergies that cause production to occur inside the firm are classic economic
externalities. If interdependencies in production or demand functions exist, the market price does not capture
these interdependencies. The same occurs inside the firm and causes the external price to mismeasure the
opportunity cost of one more unit being transferred. 12This point has been recognized by others. As one notes, “observed market prices cannot directly guide the
owner of the input to perform in the same manner as if every activity he performs were measured and priced.”
In S. Cheung (1983), “The Contractual Nature of the Firm,” Journal of Law & Economics 26 (April), 5.
558 Part 3 Designing Organizational Architecture
marginal cost is below its average total cost, manufacturing’s fixed costs are not re- covered. Thus, manufacturing appears to be losing money.13
One variant of marginal-cost transfer pricing is to use a two-part price—to price all transfers at marginal cost while also charging distribution a fixed fee for these ser- vices. Distribution pays marginal cost for the additional units and buys the number of units that maximize the firm’s profits. Unlike straight marginal-cost pricing, this variant allows manufacturing to cover its full cost and earn a profit. The fixed fee represents the rights by distribution to acquire the product at marginal cost, and it is set to cover manufacturing’s fixed cost plus a return on equity.
Another problem with marginal-cost transfer pricing occurs in situations where the marginal cost per unit is not constant as volume changes. Suppose the marginal cost per unit increases as volume expands (say, a night shift is added with higher wages per hour). If marginal cost is greater than average cost and all users are charged the higher marginal cost, the total charged to all the users is greater than the total cost incurred by the firm. Users who did not expand their volume will still see their costs increase. In such cases, conflicts are likely within the firm over the appropriate measure of mar- ginal cost and whether all users should pay the higher marginal cost or just those users who expanded output, thereby prompting the addition of the night shift.
A similar problem arises when manufacturing approaches capacity. To illustrate the problem, let’s assume that manufacturing is considering a $2.5 million outlay to add more capacity. These capacity additions costs of $2.5 million are variable in the long run but become short-run fixed costs (depreciation and higher utilities and maintenance). Thus, conflicts arise between manufacturing and distribution as to whether these additional capacity costs should be included in the transfer price or not. Such conflicts are difficult to resolve because no indisputably objective method exists for calculating marginal costs. They are not reported in The Wall Street Jour- nal. Instead, they have to be estimated, normally as “variable costs,” from account- ing records. Although many of the components of marginal cost are easily observed, such as the cost of direct labor and direct material, some components are quite diffi- cult to estimate. For example, the additional costs imposed on the purchasing de- partment when additional units are manufactured are not easily observed and hence difficult to estimate precisely.
Marginal-cost transfer pricing also creates incentives for manufacturing to distort marginal cost upward, perhaps by misstating some fixed costs as variable. For ex- ample, how much of the electricity bill is fixed and how much is variable? Since these classifications are to some extent arbitrary, resources are wasted as managers in manufacturing and distribution debate various costs and their allocations—and as senior managers are forced to spend time arbitrating such disputes.
Moreover, under marginal-cost transfer pricing, manufacturing can have an in- centive to convert a dollar of fixed costs into more than a dollar of marginal costs—for example, by using higher-priced outsourcing of parts instead of cheaper internal manufacturing—even though this clearly reduces the value of the firm. For manufacturing, the use of outsourcing can remove the burden of any fixed costs while distribution, as well as the firm as a whole, bears the additional cost of such decisions.
13Of course, if central management knows the magnitude of the fixed costs, it can budget for this loss. But,
once again, if central management knew the magnitude of the fixed costs, then it would know marginal cost,
and thus there would be little reason to have a separate, decentralized business unit and transfer-pricing
system in the first place.
Chapter 17 Divisional Performance Evaluation 559
Full-Cost Transfer Prices Because of the information and incentive problems described earlier, simple, objective, hard-to-change transfer-pricing rules can lead to higher firm value than transfer-pricing rules that give one manager discretion over the transfer price. Objective transfer-pricing rules such as those based on full accounting cost often are adopted primarily to avoid un- productive disputes over measuring marginal costs. Since full cost is the sum of fixed and variable cost, full cost cannot be changed simply by reclassifying a fixed cost as a variable cost.
The problem, however, is that full-cost transfer pricing frequently overstates the opportunity cost to the firm of producing and transferring one more unit internally. And so distribution usually will buy too few units internally. Full cost also allows manufacturing to transfer any of its inefficiencies to distribution. Thus, manufactur- ing has less incentive to be efficient under a full-cost transfer-price rule.14
Despite all these problems, however, full-cost transfer pricing is quite common. In various surveys of corporate practice, full-cost transfer prices are used 40–50 percent of the time.15 In most cases, moreover, the definition of full cost includes both direct materials and labor as well as a charge for overhead.
One reason for the popularity of full-cost transfer prices is their ability to deal with the problem of changes in capacity. As a plant begins to reach capacity, oppor- tunity cost is likely to rise because of congestion and the cost of alternative uses of now-scarce capacity. Hence, opportunity cost is likely to be higher than direct materials and labor costs. In this case, full cost might be a closer approximation to opportunity cost than just the cost of materials and labor.
Perhaps the most important benefit of full-cost transfer pricing, however, is its simplicity and hence its low cost of implementation. Because of its simplicity and objectivity, full-cost transfer pricing reduces influence costs. That is, because operating managers have less ability to manipulate full-cost than marginal-cost calculations, senior management faces fewer calls to arbitrate disputes over calculat- ing the transfer price. Nonetheless, managers should consider carefully whether full- cost pricing is appropriate for their particular situation. If the opportunity cost differs materially from full cost, the firm’s forgone profits can be substantial.
Negotiated Transfer Prices Transfer prices can be set by negotiation between manufacturing and distribution. This method can result in transfer prices that approximate opportunity cost because manufacturing will not agree to a price, that is, below its opportunity cost and distri- bution will not pay a price above what it can buy the product elsewhere.
With negotiated transfer prices, the two divisions have the incentive to set the number of units so as to maximize the combined profits of the two divisions. Once the value-maximizing number of units is established, the transfer price determines how the total profits are divided between the two divisions. In terms of Figure 17.1, if the two divisions negotiate over both price and quantity, they have the joint
14J. Zimmerman, (2014) Accounting for Decision Making and Control, 8th edition (McGraw-Hill Education: New York), Chapter 5.
15Technical note: To be sure, marginal-cost transfer prices also allow the selling division to export some of its inefficiencies to the purchasing division, but the problem is not as pronounced as under full cost.
Nonetheless, the problem of exporting inefficiencies to the buying division through cost-based transfer
prices is reduced if the purchasing division can purchase externally as well as from the selling division. This
forces the selling division to remain competitive.
560 Part 3 Designing Organizational Architecture
incentive to set Q � 10 because this maximizes the total profit to be split—$500. Yet if the two divisions just negotiate over price, there is no guarantee they will arrive at the transfer price that maximizes the firm’s value.
While negotiation is a fairly common method, it too has drawbacks. It is time- consuming and can produce conflicts among divisions. Divisional performance mea- surement becomes sensitive to the relative negotiating skills of the two division man- agers. Moreover, if the two divisions negotiate a transfer price without at the same time agreeing on the quantity to be transferred at that price, there is no guarantee that they will arrive at the transfer price that maximizes the firm’s value.
Reorganization: The Solution If All Else Fails
In some cases, transfer-pricing conflicts among profit centers can become suffi- ciently divisive to impose large costs on the firm. These costs take the form of both influence costs and the opportunity costs that arise when other than firm-value- maximizing transfer prices are chosen. Costly transfer-pricing disputes usually occur when the relative volume of transactions among divisions is large. In such cases, a small change in the transfer price can have a large effect on the division’s reported profits. Hence, the potential for (and destructive effects of) opportunistic transfer- pricing actions by operating managers is substantial.
If transfer pricing becomes sufficiently dysfunctional, reorganize the firm. For ex- ample, senior management could combine two profit centers with a large volume of transfers into a single division. Alternatively, it might make more sense to convert manufacturing into a cost center rather than a profit center and compensate the oper- ating head based on efficiency of production. Or, senior management might even or- ganize both divisions as cost centers and keep the pricing and quantity decisions at a higher level within the firm.
Internal Accounting System and Performance Evaluation16
Accounting costs, revenues, profits, return on investment, and residual income usually are used as performance measures of cost, expense, revenue, profit, and in- vestment centers. Accounting costs frequently are used as transfer prices. The ac- counting system is an important component of the firm’s performance-evaluation system and thus is an integral part of the firm’s control system—the performance- evaluation and reward systems. This section elaborates on accounting’s role within the firm.
Uses of the Accounting System
Many people think of the firm’s accounting system in terms of its external financial reports—balance sheets and income statements—to the shareholders, taxing author- ities, regulators, and lenders. These external financial reports (both quarterly and annual) are an incredibly aggregated view of the enormous amount of data produced
16This section draws on analysis in Zimmerman (2014).
Chapter 17 Divisional Performance Evaluation 561
internally. Internally, managers rely on detailed operating reports of expenses, prod- uct costs, and customer account balances from the accounting system.
These internal reports are used by management for two general purposes: decision management and decision control. The decision-making process can be divided into decision management (initiation and implementation) and decision control (ratifica- tion and monitoring). Managers frequently have both decision-management and decision-control rights, but normally not for the same decisions. Senior managers in the firm tend to hold more decision-control rights, whereas decision-management rights tend to be delegated to managers lower in the firm. To exercise either decision- management or decision-control rights, managers require information. Some of that information is provided by the accounting system. Thus, although the accounting system is used for both decision management and decision control, its primary func- tion within most firms is decision control.
Decision management requires estimates of future costs and benefits. Initiating an investment decision to build a new plant requires the manager to forecast future al- ternative uses of this plant; designing a marketing campaign requires judgments of likely future sales and competitors’ responses. Managers frequently use accounting- based data as inputs to these decisions. Accounting numbers provide a starting point in forecasting future consequences of proposed actions. Most firms have accounting- based budget systems. Managers forecast costs and revenues for the next year in preparing their budgets. This process encourages managers to be forward-looking, to coordinate their operations with those managers most directly affected by their deci- sions and to share specialized knowledge of their markets and production technolo- gies. Accounting-based budgets provide the framework for such coordination and knowledge sharing.
Although helpful for decision management, accounting systems generally are more useful for decision control (ratification and especially monitoring). In fact, this is the primary reason they evolved. Accounting systems are based on historical costs and historical revenues. Historical costs record what the firm paid for its current re- source base and in this sense are backward-looking. Internal accounting systems pro- tect against theft of company assets, fraud, and embezzlement. They also provide a scorecard to show how a business unit did historically by measuring costs, profits, or residual income. Monitoring is by definition a historical function, one well served by the accounting system. Since accounting systems are primarily used for decision control—to prevent malfeasance and to measure past performance—when it comes to providing managers with information for decision management, accounting sys- tems often are found wanting.
Trade-offs between Decision Management and Decision Control
Considering how the accounting system is used for both decision management and decision control leads to a number of important insights. First, accounting measures, to the extent that they are used for monitoring purposes, are not under the complete control of the people being monitored—the operating managers.
Second, managers with decision-management rights tend to be dissatisfied with financial measures for making operating decisions. The data often are reported at such a high level of aggregation that it does not provide sufficient detail for the decision. In response, operating managers develop their own, often nonfinancial,
562 Part 3 Designing Organizational Architecture
information systems to provide more of the knowledge required for decision man- agement. But at the same time, they rely on accounting-system output to monitor the managers who report to them.
Third, nonaccounting measures frequently are more timely than accounting mea- sures. Not every decision requires ratification or monitoring. Decision monitoring can be based on aggregate data to average out random fluctuations. Instead of mon- itoring every machine setup, it usually is more effective to aggregate all setups occurring over the week or month and make sure the average setup cost is within acceptable levels.
One survey reports that managers rely on nonfinancial data (labor counts, units of output, units in inventory, units scrapped) to run their day-to-day operations. But when they are asked about their “most valuable report in general,” they say it is the monthly income or expense statement because in part this is one of the measures used to judge their performance.17
In choosing among alternative accounting systems, managers often must make trade-offs between decision management and decision control. Consider the transfer-pricing decision. The transfer-pricing method that most accurately measures the opportunity cost to the firm of transferring one more unit inside the firm might not be the transfer-pricing method that gives internal managers the most effective in- centives to maximize the firm’s value. For example, if the transfer-pricing method that most accurately measures the opportunity cost of units transferred (decision management) also requires manufacturing to reveal privately held and hard-to-verify
M A N A G E R I A L A P P L I C AT I O N S
Massive Financial Fraud at Cendant In the vast majority of cases, there are sufficient controls such as internal and external auditors to ensure that the firm’s
accounting reports accurately reflect the organization’s financial performance. However, in rare situations, the
managers have “cooked the books.” Take the case of the bankrupt Adelphia Communications that agreed to pay more
than $700 million to settle “one of the most extensive financial frauds ever to take place at a public company,”
according to the U.S. Securities and Exchange Commission (SEC). John Rigas founded Adelphia and grew it into the
fifth largest cable TV provider in the United States. The SEC charged that Adelphia: (1) fraudulently excluded billions
of dollars in liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet
affiliates; (2) falsified operations statistics and inflated earnings to meet Wall Street’s expectations; and (3) concealed
rampant self-dealing by the Rigas family, including the undisclosed use of corporate funds for Rigas family stock
purchases and the acquisition of luxury condominiums in New York and elsewhere. The United States Attorney’s
Office also filed related criminal charges against several of the same defendants. In settling the case the Rigas family
forfeited 95 percent of its assets–totaling more than $1.5 billion. After the Rigases left the management of Adelphia,
the company claimed to be owed more than $3.2 billion from the Rigases, who “seemingly ran the company as if it
were their own private cash machine.” John Rigas and his son Timothy, the former chief financial officer, were
convicted on 18 counts of securities fraud, bank fraud, and conspiracy. John Rigas at age 83 began serving a 15-year
prison term, while his son, Timothy, was sentenced to 20 years in prison. In 2006 the majority of Adelphia’s assets
were acquired by Time Warner Cable and Comcast.
Source: D. Cook (2005), “Adelphia, Rigas Family Settle Fraud Case,” CFO.com (April 26), www.cfo.com/article.cfm/3907889;
Associated Press (2008), “Adelphia Communications founder, son lose final appeal on fraud convictions,” (March 3); www.sec.gov
/news/press/ 2002-110.htm.
17S. McKinnon and W. Bruns (1992), The Information Mosaic (Harvard Business School: Boston).
Chapter 17 Divisional Performance Evaluation 563
knowledge of costs, then manufacturing has substantial discretion over the transfer prices. If these prices are important in rewarding managers (decision control), man- ufacturing can distort the system to its benefit. Given the reward system, a transfer- pricing method, that is, less subject to managerial discretion might in the end be a more accurate measure of opportunity costs than one that requires managers to dis- close private, hard-to-verify knowledge.
ANALYZING MANAGERIAL DECISIONS: Celtex
Celtex is a large, quite successful, decentralized
specialty chemical producer organized into five in-
dependent investment centers. Each of the five
investment centers is free to buy products either
inside or outside the firm and is judged based on
residual income. Most of each division’s sales are
to external customers. Celtex has the general rep-
utation of being one of the top two or three com-
panies in each of its markets.
Leopoldo Garcia, president of Synchem,
Celtex’s synthetic chemicals division, and Walid
Murad, president of the consumer products divi-
sion, are embroiled in a dispute. It all began two
years ago when Wally asked Leo to modify a
synthetic chemical for a new household cleaner.
In return, Synchem would be reimbursed for out-
of-pocket costs. After Synchem spent considerable
time perfecting the chemical, Wally solicited com-
petitive bids from Leo as well as several outside
firms; he then awarded the contract to one of the
outside firms, which was the low bidder. This
annoyed Leo, who expected his bid to receive
special consideration because he developed the
new chemical at cost, yet the outside vendor took
advantage of his division’s R&D.
The current conflict has to do with Synchem’s
producing chemical Q47, a standard product, for
consumer products. Because of an economic slow-
down, all synthetic chemical producers have excess
capacity. Synchem was asked to bid on supplying
Q47 for consumer products. Consumer products is
moving into a new, experimental product line and
Q47 is one of the key ingredients. Although the
magnitude of the order is small relative to
Synchem’s total business, the price of Q47 is quite
important in determining the profitability of the ex-
perimental line. Leo bid $3.20 per gallon. Meas
Chemicals, an outside firm, bid $3. This time,
Wally is annoyed because he knows that Leo’s bid
contains a substantial amount of fixed overhead
and profit. Synchem buys the base raw material,
Q4, from the organic chemicals division of Celtex
for $1 per gallon. Organic chemical’s out-of-pocket
costs (i.e., variable costs) are 80 percent of the
selling price. Synchem then further processes Q4
into Q47 and incurs additional variable costs of
$1.75 per gallon. Allocated fixed overhead adds an-
other $.30 per gallon.
Leo argues that he has $3.05 of cost in each gal-
lon of Q47. If he turned around and sold the product
for anything less than $3.20, he would be under-
mining his recent attempts to get his salespeople to
stop cutting their bids and start quoting full-cost
prices. Leo has been trying to enhance the quality of
the business he is getting, and he fears that if he is
forced to make Q47 for consumer products, all of
his effort the last few months would be for naught.
He argues, “I already gave away the store once to
consumer products and I won’t do it again.” He
questions, “How can senior managers expect me to
return a positive residual income if I am forced to
put in bids that don’t recover full cost?”
Wally, in a chance meeting at the airport with
Diana Philapados, senior vice president of Celtex,
described the situation, and asked Philapados to
intervene. Wally believed Leo was trying to get
even after their earlier clash. Wally argued that the
success of his new product venture depended on
being able to secure a stable, high-quality source of
supply of Q47 at low cost.
Diana has hired you as a consultant and has
asked you to do the following:
1. Prepare a statement outlining the cash flows to
Celtex of the two alternative sources of supply
for Q47.
2. Offer advice regarding how Diana should han-
dle the issues raised by Wally.
564 Part 3 Designing Organizational Architecture
All accounting (as well as nonaccounting) performance measures are prone to managerial opportunism in the form of accounting manipulations and dysfunctional decisions. In other words, accounting numbers are prone to gaming. Managers can choose depreciation methods that reduce expenses and increase reported earnings (straight-line depreciation). These accounting choices artificially raise ROA. Invest- ment center managers can increase ROA by rejecting (or divesting) profitable projects with ROAs below the average ROA of the division. Most accounting mea- sures are short-term measures of performance. They all suffer from the horizon prob- lem, whereby managers emphasize short-term performance at the expense of long- term returns. Therefore, any accounting-based performance-measurement system requires careful monitoring by senior managers to control dysfunctional behavior by lower-level managers.
In the United States, accounting methods are regulated and managers must choose accounting methods from generally accepted accounting procedures (GAAP). Yet managers still have considerable discretion. External, third-party auditors ensure the accuracy and consistency of the accounting reports. Most firms employ a single ac- counting system for multiple purposes: reporting to shareholders, taxes, internal de- cision management and control, and regulation.18 Debt agreements, management compensation plans, and financial reports all use these accounting-based numbers. Using the same numbers for many purposes helps control the incentives to distort the numbers for any single purpose.
Finally, no performance-measurement and reward system works perfectly; no sys- tem eliminates all managerial decisions that will increase the manager’s welfare at the expense of the firm’s other claimholders. The key question is: Does the system outperform the next best alternative after all the costs and benefits are included? One should avoid the “nirvana fallacy,” which suggests discarding a system because it fails to eliminate all managerial opportunism. The nirvana fallacy arises when one compares a real system to a hypothetical but unachievable “perfect” system.19
Summary Decision rights are allocated to cost, expense, revenue, investment, and profit cen- ters. These centers often are evaluated and rewarded based on accounting-based per- formance measures. Cost centers are delegated decision rights over how to produce the output, but not over price or quantity. Cost centers are evaluated on either mini- mizing total cost for a fixed output, or maximizing output for a fixed total cost. Ex- pense centers such as the human resources department are like cost centers except that their output is not easily quantifiable. This difficulty in quantifying output means users often are not charged for the expense center’s output; hence the demand for expense center services tends to grow faster than the firm’s output.
Revenue centers also are similar to cost centers, with the difference that they are responsible for marketing the products. They have decision rights over how to sell or distribute the product, but not over the price-quantity decision. Revenue centers are evaluated on maximizing revenue for a given price or quantity and a fixed budget for operating expenses.
18Even though the firm has “one” accounting system, the accounting numbers often are adjusted for special
purposes. For example, the system may use straight-line depreciation for shareholders but adjust these
numbers to accelerated depreciation for taxes. 19H. Demsetz (1969), “Information and Efficiency: Another Viewpoint,” Journal of Law & Economics XII, 1–22.
Chapter 17 Divisional Performance Evaluation 565
Profit centers have all the decision rights of cost centers plus product mix and pricing decisions. They do not have decision rights over the level of investment in their profit center. Profit centers are evaluated based on total profits. Finally, invest- ment centers are like profit centers except that they also have decision rights over the amount of capital invested in their division. Evaluating performance of investment cen- ters involves adjusting profits for the amount of capital invested. Two commonly used investment center measures are return on assets and residual income (or EVA). Both measures create incentives for managers to eliminate assets that are not covering their opportunity cost of capital. However, ROA gives incentives to eliminate prof- itable projects with returns below the average ROA for the division. Residual income avoids this incentive problem, but as a performance measure it makes comparing di- visions of different sizes more difficult.
Large companies, particularly those operating across multiple lines of business, typ- ically are organized into multiple business units or divisions. Such an organizational architecture is intended to furnish senior managers with information about the prof- itability or efficiency of different businesses and to provide accountability and incen- tives for the operating managers charged with running those businesses.
Nonetheless, when there are significant interdependencies among different busi- ness units, often involving internal transfers, motivating individual profit centers to maximize their own profits generally will not maximize profits for the firm as a whole. Individual units focusing on their own profits often will ignore how their ac- tions affect the sales and costs of other units.
One valuable role of a transfer-pricing method, then, is to lead managers to allocate resources internally in ways that take account of such interdependencies among divi- sions. But transfer pricing is a quite complicated undertaking. The likelihood of getting the wrong answer is high, and the consequences of so doing—primarily in the form of poor pricing and output decisions—can be substantial. Transfer prices not only change how total profits are divided among business units but affect total firm profits.
The opportunity cost of a transferred resource is the correct transfer price. But accurate information about opportunity cost usually is known only by local divi- sional managers. If either the buying or selling division can set the transfer price unilaterally, it has incentives to behave opportunistically. The selling division will set too high a price trying to capture monopoly profits, and too few units will be transferred. If the buying division is allowed to set the transfer price, a price below the true opportunity cost is likely to be chosen; in this case, too few units will be produced and transferred.
Because accurate information about opportunity costs is quite expensive to obtain (or at least to verify), managers generally rely on approximations such as market values, marginal costs, full costs, or negotiated prices. Each of these approximations works bet- ter than others in certain circumstances. Market-based transfer prices are most useful when competitive external markets exist. But if an external market is employed, why is the firm producing the good or service? If there are important synergies favoring inter- nal production, the external market price is unlikely to capture them. For example, if there are transaction costs of using the market, such as writing and enforcing contracts, then the transfer price is the market price less these transaction costs. Marginal cost is another popular transfer-pricing method. But marginal cost is expensive to estimate and can generate influence costs as managers debate whether certain expenditures are “marginal” or not. Full-cost transfer prices are objective, simple-to-compute transfer prices. They also are used widely in practice. However, full-cost transfer prices likely suffer from setting the transfer price above opportunity cost. Negotiated transfer prices,
566 Part 3 Designing Organizational Architecture
although time-consuming to establish, give both parties to the contract the incentive first to negotiate the quantity that maximizes the firm’s profits and then negotiate the trans- fer price that determines how the total profits will be divided.
No matter what transfer-pricing method is used, it normally is important to permit both buying and selling divisions access to the external market. In this case, the ex- ternal market acts as a check on opportunistic managerial behavior. But again, if the external market is employed regularly, one must examine whether the firm should be producing the intermediate product at all.
Finally, most divisional performance-evaluation systems rely on internally gener- ated accounting-based numbers. These accounting-based performance metrics are for decision control (decision ratification and decision monitoring). Besides exercising decision-control rights, employees also exercise decision-management rights (deci- sion initiation and implementation). Exercising decision-management rights requires information; often managers turn to their accounting systems for this information. But the accounting systems of most firms are designed for decision control—not neces- sarily for decision management. This leads to a trade-off between these two uses and to the general conclusion that most managers find their accounting systems wanting when it comes to providing information for decision management.
R. Eccles (1985), The Transfer Pricing Problem: A Theory for Practice (Lexington Books: Lexington).
J. Gould (1964), “Internal Pricing in Firms When There Are Costs of Using an Outside Market,”
Journal of Business 37, 61–67.
J. Hirshleifer (1964), “Internal Pricing and Decentralized Decisions,” in C. Bonini, P. Jaediecke,
and R. Wagner (Eds.), Management Controls: New Directions in Basic Research (McGraw-Hill: New York).
B. Holmstrom and J. Tirole (1991), “Transfer Pricing and Organizational Form,” Journal of Law, Economics, and Organizations 7, 201–228.
D. Solomons (1985), Divisional Performance: Measurement and Control, 2nd edition (Richard D. Irwin: Burr Ridge, IL).
B. Stewart (1991), The Quest for Value (Harper Business: New York).
J. Zimmerman (2014), Accounting for Decision Making and Control, 8th edition (McGraw-Hill Education: New York).
17–1. Chips Computer Company assembles personal computers and sells them in the retail market- place. The company is organized into two profit centers: the assembly division and the
distribution division. The demand curve facing the company (and the distribution division)
is P � 3,000 � 10Q. The marginal cost for assembly (which includes purchasing the parts) is constant at $500. The distribution division faces constant marginal distribution costs of
$50 per unit.
a. What is the profit-maximizing retail price and output for the firm as a whole? b. If the assembly division has monopoly power to set the transfer price, what transfer
price will it select (assuming it knows all the information above)? Calculate the profits
for the two divisions in this case.
17–2. Scoff Division of World-Wide Paint is currently losing money, and senior management is considering selling or closing Scoff. Scoff’s only product, an intermediate chemical called
Binder, is used principally by the latex division of the firm. If Scoff is sold, the latex divi-
sion can purchase ample quantities of Binder in the market at sufficiently high-quality levels
to meet its requirements. World-Wide requires all of its divisions to supply product to other
World-Wide divisions before servicing the external market.
Self-Evaluation Problems
Suggested Readings
Chapter 17 Divisional Performance Evaluation 567
Scoff Division Profit/Loss Last Quarter (in thousands of dollars)
Scoff’s statement of operations for the latest quarter is as follows:
Revenue: Inside $200 Outside 75 $275
Operating expenses: Variable costs $260 Fixed costs 15 Allocated corporate overhead 40 315
Net income (loss) before taxes $(40)
Notes: 1. World-Wide Paint has the policy of transferring all products inter-
nally at variable cost. In Scoff’s case, variable cost is 80 percent of the market price.
2. All of Scoff’s fixed costs are avoidable cash flows if Scoff is closed or sold.
3. Ten percent of the allocated corporate overhead is caused by the presence of Scoff and will be avoided if Scoff is closed or sold.
Calculate the annual net cash flows to World-Wide Paint of closing or selling Scoff.
Solutions to Self-Evaluation Problems 17–1. Chips Computer Transfer Prices
a. The profit-maximizing retail price and quantity are found as follows:
Profit maximization:
b. Assembly Division has monopoly power: Distribution Division’s demand:
Assembly Division maximizes profits by selecting:
Profits for Distribution:
[$2,387.5 (retail price) � 61.25] � [61.25 (1,725 � 50)] � $37,516
Profits for Assembly Division:
61.25 (1,725 � 500) � $75,031
PT � $ 1,725 Q � 61.25
2,450 � 40Q
2,950 � 40Q � 500
PT � 2,950 � 20Q
PT � 50 � 3,000 � 20Q
P � $ 1,775 (from the demand curve) Q � 122.5
2,450 � 20Q
3,000 � 20Q � 550
MC � 500 � 50 � 550
MR � 3,000 � 20Q
P � 3,000 � 10Q
568 Part 3 Designing Organizational Architecture
17–2. Division Closing at World-Wide Paint
The key to this problem is recognizing that the transfer price is quite favorable to the latex
division and is causing Scoff to appear unprofitable. If Scoff is closed or sold, the latex divi-
sion will have to pay the market price for Binder, which is higher than the current transfer
price. Also, not all of the corporate overhead is saved by closing or selling Scoff.
Selling or closing Scoff changes the potential synergies within the firm. Can World-
Wide Paint maintain the same quality/delivery times on Binder? One question to raise is
what these are worth. Having to analyze these “intangibles” will only be necessary if an
outside offer is larger than the value of the cash flows forgone from selling Scoff. The
table below indicates that Scoff is generating positive cash flow to World-Wide despite
the operating losses reported.
Quarterly Net Cash Flows to World-Wide Paint from Closing Scoff Division Last Quarter Ending ($ thousands)
Operating expenses saved: Variable costs $260 Fixed costs 15 Allocated corporate overhead 4_____
Scoff’s operating expenses avoided $279
Revenues forgone: Outside (75)
Market purchases by latex division of Binder ($200 � 80%) (250)______
Decline in quarterly cash flows ($46) � 4 quarters per year � 4––––––
Annual decline in World-Wide cash flows ($184) ––––––
17–1. Auto-fit is a multidivisional firm that produces auto parts. It has the capacity for annual production of 100 units of a particular part. The marginal cost of producing each unit is
$10. These units can be sold internally either to other divisions or to external customers.
The external market price is $20. The allocated share of corporate overhead for each part
produced is $5. Total corporate overhead expenditures do not vary with the production of
the part. How many units of the part should the company produce? What is the theoreti-
cally correct transfer price (should the company decide to transfer the part internally)?
Explain.
17–2. High Tech, Inc., has strong patent protection on a particular type of computer chip. High Tech uses the chip for the internal production of PCs. It also sells the chip to other manu-
facturers on the open market. Does High Tech necessarily want to charge the same price to
both external and internal customers? Explain.
17–3. A firm has a demand curve: P � 50 � Q. Its total costs are
TC � 110 � Q � 3Q 2
Prepare a table that computes the profit-maximizing quantity. What quantity minimizes av-
erage cost? (Hint: Prepare a table similar to Table 17.1 for Q � 1, 2, . . . 10.)
17–4. The Xtrac Computer Company is organized into regional sales offices and a manufactur- ing division. The sales offices forecast sales for the upcoming year in their territories.
These figures are then used to set the manufacturing schedules for the year. Prices of the
Review Questions
Chapter 17 Divisional Performance Evaluation 569
computers are determined by corporate headquarters, and the salespeople are paid a
fixed wage and a commission on sales. The regional sales offices are evaluated as rev-
enue centers. The regional sales manager is paid a small wage (about 30 percent of total
pay) and a commission on all sales in her territory (about 70 percent of total pay) that
exceeds the budget.
Xtrac has a notoriously bad track record for forecasting computer sales. Its budgets
always underforecast sales, and then, during the year, manufacturing scrambles to
produce more units, authorizes labor overtime, and buys parts on rush orders. This dri-
ves up manufacturing costs. At first, management thought the underforecasting problem
was due to high unexpected growth in the computer industry. But Xtrac even underfore-
casts sales when the economy is slow and the industry growth is below its long-run
average.
a. What is the likely reason Xtrac persistently underforecasts sales? b. What are some likely explanations for the reason in part (a)? c. Propose three likely solutions and critically evaluate each of them.
17–5. Suppose a firm has two different accounting systems. For example, suppose it uses EVA to measure and reward management performance. To calculate EVA, annual spending on re-
search and development is recorded as an asset and then depreciated in calculating earnings.
In reporting earnings to shareholders, R&D spending in any given year is expensed against
earnings.
Describe some of the likely consequences that can arise if the firm tries to maintain two
different accounting systems.
17–6. An organizational consultant does not like the way your company compensates profit center managers (currently a large part of their pay is based on the center’s profits). He
argues that you should compensate the managers based on whether or not they made
“reasonable decisions” and not based on the outcome of the decisions, which is partly
beyond the control of the managers. The consultant argues that the managers will then have
incentives to make good decisions but will not be subject to undue levels of risk. Evaluate
this argument.
17–7. Below is a suggestion from a leading economics text on how to set optimal transfer prices. In this context, both the manufacturing and distribution divisions are profit centers. Do you
think it would work? Explain.
The manufacturing division could be supplied data on the net marginal revenue curve for the distribution division and told to use this as its relevant marginal revenue curve in determining the quantity it should supply. By choosing the output where marginal revenue equals marginal cost, firm profits are maximized. The transfer price should be the marginal cost at this output level.
17–8. Xerdak Inc. has a corporate jet, which it uses to fly managers from Rochester to Chicago. The associated costs (monthly) of maintaining and flying the jet are as follows:
Pilot: $10,000
Depreciation: 10,000
Overhead: 10,000
In addition, each round trip to Chicago costs $10,000 in fuel. Commercial airlines (e.g.,
United) charge $600 for a round trip to Chicago. Managers consider the commercial service
and the company service to be identical. The company plane flies a maximum of 20 times
each month and has 50 seats. There are always more managers wanting to fly on the plane
than there are seats. The company wants to buy some more planes. Unfortunately, they are
back-ordered, and so the company will not be able to obtain additional capacity in the near
future. According to economic theory, what is the optimal transfer price for a round trip to
Chicago? Explain why.
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17–9. Geriatrics Inc. has a patent on a new type of hospital bed. The marginal cost of producing each bed is $400. The company has significant production capacity. Geriatrics sells the
beds to customers on the open market and also uses them internally throughout its nursing
home chain. The external demand for the product is given by P � 5,000 � Q. Assuming that Geriatrics wants to profit-maximize, what is the optimal external market price? What
is the optimal internal transfer price?
17–10. Biotech Inc. is a new company that invests in technologies relating to the use of plants in drugs. The stock market perceives that the company has the potential to generate large
profits once it develops a line of products. To date, however, the company has not reported
positive profits and does not anticipate doing so over the next five years or more. The own-
ers of Biotech are particularly concerned about the investment choices of the managers.
They are concerned that the managers do not have the right incentives to choose value-
maximizing investments. They are considering adopting an EVA evaluation and compen-
sation plan for the managers. Do you think this is a good idea? Explain.
17–11. Speed Company sells printers. It is divided into a manufacturing unit and a sales unit. The marginal cost of producing a printer is $200. External demand is given by P � 1,000 � 0.01Q. Selling and distribution costs total $150 per unit.
a. What is the profit-maximizing retail price and quantity? What are firm profits? b. Suppose the manufacturing unit has monopoly power to set the transfer price and
knows all the information in this problem. What transfer price will it charge? What are
the resulting retail price, quantity, and firm profits?
17–12. Do you agree with the following statement? Explain.
Obviously the correct transfer price is the opportunity cost of the resource. Any firm that uses full cost (which includes an allocation of corporate overhead) is doing it wrong.
17–13. You are the owner and CEO of a large divisionalized firm, with operations in a number of diverse industries. Reporting to you are a number of division managers. Division managers
have considerable decision-making responsibility with respect to the day-to-day operations
of their divisions, but you must approve any capital investments above $100,000 before they
are made.
a. As owner, what type of capital investments would you like your division managers to be proposing to you?
b. Is there a potential agency problem between you, as owner, and your division managers with respect to capital investments? What is the nature of that problem? Why is it a
problem?
c. How might you attempt to solve that agency problem? d. Do you think you can solve the problem entirely? Why or why not?
17–14. The Jameson Company has recently formed a subsidiary, Bright Ideas, to manufacture and sell household appliances.
a. What is the difference between an investment center and a profit center? b. What factors should Jameson consider in deciding whether to evaluate Bright Ideas as
a profit or investment center?
C A P S T O N E C A S E S T U D Y O N O R G A N I Z A T I O N A L
A R C H I T E C T U R E
Arthur Andersen LLP1
Introduction and Overview
It is difficult to find an example of a more spectacular business failure than the col- lapse of Arthur Andersen in 2002. Within a few years, Andersen moved from one of the largest professional service organizations in the world to extinction. The impact of the firm’s failure on its employees, customers, investors, and the general public is hard to overstate. Its once proud reputation had been reduced to shambles. Even the President of the United States joked:
We just received a message from Saddam Hussein. The good news is that he’s willing to have his nuclear, biological, and chemical weapons counted. The bad news is he wants Arthur Andersen to do it.2
The dramatic demise of Andersen (along with the failures of companies such as Enron and Global Crossing) has raised concerns among managers throughout the world. They want to understand what caused the collapse of the company so that they can take actions to avoid similar fates.
Over the years, Andersen’s business environment and strategy changed in material ways. Their management responded by making associated changes in their organiza- tional architecture (decision right, performance evaluation, and reward systems). Chapters 11–17 of this book have argued that ill designed organizational architectures can result in poor performance and even company failure. An important question is whether Andersen’s failure can be traced to inappropriate organizational choices. An even more critical question is whether other managers can learn from Andersen’s mistakes. We believe that the answer to both questions is yes.
Our case study begins by summarizing the history and events that led to the col- lapse at Arthur Andersen. This discussion is followed by a series of questions that ask the reader to analyze the demise of Andersen in the context of the framework in- troduced in this book. Our purpose is not to present all the relevant analysis our- selves. Rather it is to provide readers with the opportunity for an integrated analysis and capstone discussion of an important business problem that relies on material drawn from across Chapters 11–17 of this book. It also provides a forum for
571
1This case study is based on public news accounts, company documents, and press releases. Among the most
important sources are K. Brown and I. J. Dugan (2002), “Sad Account: Andersen’s Fall from Grace Is a Tale
of Greed and Miscues,” The Wall Street Journal, (June 7); and a series of articles from the Chicago Tribune published in September 2002.
2Joke made by President George W. Bush at a dinner talk in January 2002 as quoted in the MBA Jungle, December 2002–January 2003, 70.
discussing the root causes of the business scandals that rocked the international busi- ness community.
Arthur Andersen: The Early Years
A 28-year-old Northwestern accounting professor named Arthur Andersen started his own business in 1914. Andersen’s strategy was to offer high-quality accounting services to clients—promoting integrity and sound audit opinions over higher short- run profits. Soon after Andersen formed the firm, the president of a local railroad demanded that he approve a transaction that would have lowered his company’s ex- penses and increased its reported earnings. Andersen, who was not sure he could even meet his firm’s payroll, told the president that there was “not enough money in the city of Chicago” to make him do it. The president promptly severed his rela- tionship with Andersen. However, Andersen soon was vindicated when the railroad filed for bankruptcy a few months later.
In the 1930s, the federal government adopted new laws to require public com- panies to submit their financial statements to an independent auditor every year. These regulatory changes, along with Andersen’s reputation, helped the firm to grow. During these formative years, the organization continued to promote its “four cornerstones” of good service, quality audits, well-managed staff, and prof- its for the firm. Quality audits were valued more than higher short-run firm profits. Leonard Spacek, who succeeded Andersen as managing partner in 1947, produced more company folklore when he accused powerful Bethlehem Steel of overstating its profits in 1964 by more than 60 percent. He also led a crusade to motivate the Securities and Exchange Commission to crack down on companies that cooked their books. The yellowing press clippings of his bold efforts were still on display at the company’s main training center near Chicago in 2002.
Between 1914 and the late 1980s, “tradition was everywhere” at Arthur Andersen. The firm installed heavy wooden doors at the entrance of all its offices. Andersen employees were known to be “one of a kind”—clean-cut, straightlaced, and dressed in pinstripes. Employees were taught to recite the partnership’s motto, “Think straight, talk straight.” Auditors were rewarded and promoted for making sound audit decisions. Top management assigned significant decision rights to the central of- fice’s Professional Standards Group. This group, which consisted of internal experts, monitored audits and issued opinions on how specific types of transactions should be handled. The objective was to promote consistent and well-reasoned opinions throughout the firm.
Andersen’s insistence on quality and high standards enhanced its reputation and promoted consistent growth. Auditors in the firm did not become wealthy in these formative years. However, Andersen partners were well respected within their local communities and earned enough to purchase comfortable houses, nice cars, and memberships at local country clubs. In the late 1960s, a mid-level partner at Arthur Andersen made about $30,000—or $213,000 in 2014 dollars.
Andersen Enters the Consulting Business
In 1950, an Andersen engineer named Joseph Glickauf demonstrated that computers could be used to automate bookkeeping. This event led to monumental changes in the partnership. In addition to its basic auditing function, Andersen also could help
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Capstone Case Study 573
clients automate their accounting systems. The firm launched its new computer con- sulting business in 1954 when it began providing services to General Electric’s state- of-the-art appliance factory near Louisville, Kentucky. Andersen soon developed the largest technology practice of any accounting firm.
During the 1950s and 1960s, the consulting business grew but remained a rela- tively minor activity compared to Andersen’s auditing business. During the 1970s, Andersen’s consulting business exploded as the demands for information technology increased. By 1979, 42 percent of Andersen’s $645 million in worldwide fees came from consulting and tax work, as opposed to auditing and accounting. Consulting became the leading contributor to Andersen’s revenues and bottom line in the mid-1980s.
Family Feud
As Andersen’s consulting business continued to grow, tensions within the firm mounted. The consultants, who were contributing more to profits than the auditors, felt that they were subsidizing the audit partners. Consultants began to realize that they were underpaid relative to their market opportunities. Auditing partners re- sented the fact that the consultants wanted a higher share of the profits. The auditing partners, who controlled the managing board, made few concessions to the consult- ing partners. In response, a number of the top consultants left Andersen for other firms or to start their own consulting businesses.
Because of mounting tension, the firm separated its consulting and auditing busi- nesses in 1989 by forming a new Geneva-based holding company, Andersen World- wide (AW). Under the AW umbrella were two subsidiaries, Andersen Consulting (AC) and Arthur Andersen (AA). AC was to focus on providing consulting services to large corporations (primarily in the areas of computer systems integration and business strategy). AA, in turn, would focus primarily on audit and tax engagements. However, AA was allowed to provide consulting services to smaller companies (an- nual revenues of less than $175 million). The more profitable business was to share part of its profits with the other unit. Compensation no longer had to be the same across consulting and auditing partners. Each unit had significant decision rights over its own business.
Strategic and Organizational Changes at Andersen
The implications for the auditing partners were grim. The traditional accounting business was growing quite slowly due to increased competition and the large num- ber of mergers in the 1990s; auditing quickly was becoming a low margin activity. Despite the long hours, accountants’ salaries began lagging behind those of other professionals, such as lawyers and investment bankers. AA accountants particularly resented being eclipsed by their consulting counterparts at AC.
The auditors decided to “fight back.” As top partner (at the time) Richard Measelle said, “it was a matter of pride.” AA adopted a new strategy that focused on generating new business and cutting costs. AA began evaluating its partners on how much new business they brought to the firm. Superb auditors “who could not get a lick of business” were secure in their jobs in the 1970s, but not in the 1990s. Ac- cording to Measelle, partners began to feel that “the number one thing was to make your numbers and to make money.”
574 Capstone Case Study
To reduce costs, AA began requiring partners to retire at age 56, enforcing a pol- icy that had long been overlooked. The increased emphasis on revenue growth and expense reduction led to substantially higher revenues and profits per partner. As the twentieth century drew to a close, the average AA partner made around $600,000. However, these new policies also led to less experienced auditors and fewer partners overseeing audits.
A new breed of partner rose to the top within this new environment. One prominent example was Steve Samek, who was in charge of the Boston Chicken audit. Top partners gave Samek high praise for “turning a $50,000 audit fee at Boston Chicken into a $3 million full-service engagement.” Samek, however, allowed the chain to keep details of losses at its struggling franchises off its own financial statements as it moved toward an initial public offering. The overstated financial statements helped make the IPO a “rousing success.” Boston Chicken’s subsequent collapse and bankruptcy led to legal actions against AA for helping to create a “facade of corporate solvency.” In 2002, AA agreed to settle these suits by paying $10 million. Samek, however, had left the Boston Chicken account in 1993 to move on to bigger and more important assignments.
Robert Allgyer was known within AA as the “the Rainmaker” due to his success at cross-selling services to audit clients. One of his biggest “successes” was Waste Man- agement, which paid $17.8 million in nonaudit fees to AA between 1991 and 1997, compared to $7.5 million in audit fees. At the same time, Allgyer was signing off on in- accurate financial statements. Among other things, the company wasn’t properly writ- ing off the value of its assets such as garbage trucks as they aged. As a result, profits were substantially overstated. In 1998, AA agreed to pay $75 million to settle share- holder suits over its auditing of Waste Management.
Boston Chicken and Waste Management were not the only problems to arise at AA over this period. In 2001, AA agreed to pay $110 million to settle shareholder suits arising from its audits of Sunbeam Corporation. These suits also arose over AA’s attestation of financial statements that were alleged to be overly positive.
Continued Changes as AA Moves into the Twenty-First Century
AC partners complained that AA’s consulting with large companies violated their in- ternal agreement to separate the two businesses—indeed, AC and AA competed for some of the same consulting engagements. In 1997, AC partners voted unanimously to split off entirely and filed a formal arbitration claim with the International Cham- ber of Commerce. Eventually AC was allowed to separate and form a new indepen- dent company, Accenture. AA partners suffered a significant financial setback when the arbitrator ruled that AA would not receive a $14 billion payment it had expected from AC upon separation.
In 1998, Samek became the managing partner at Arthur Andersen. Among his ini- tial moves was to formulate a new strategy that included advice on how partners should empathize with clients. Samek surprised many of the auditing partners when he announced his new “2X” performance evaluation system. Partners were expected to bring in two times their revenues in work outside their area of practice. If an audi- tor brought the firm $2 million a year in auditing fees, he was expected to bring in an additional $4 million in fees from nonaudit services, such as tax advice and technol- ogy services. Partners who achieved this standard were rewarded, while others were penalized and in some cases dismissed from the company.
Capstone Case Study 575
In addition to changing Andersen’s organizational architecture, Samek tried to change the softer elements of the firm’s corporate culture. For example, the dress code was relaxed, the wooden doors at Andersen’s office entrances were removed, and the firm adopted a new corporate logo, the rising sun.
Soon Andersen partners began offering a new service to clients. Rather than just handling the once-a-year audit of the public books, the firm offered to take over the entire internal bookkeeping function for their clients and provide internal audit ser- vices. Critics, such as Arthur Levitt (chairman of the SEC at the time), voiced con- cerns that this practice at least would impair the perceived quality of audits. Ac- counting firms engaged in this practice would essentially be checking their own work. In 2000, the SEC proposed new regulations that would limit the consulting work at accounting firms. In testimony before the Senate Banking Committee in July 2000, Samek called the SEC proposal “fatally flawed.” He argued that the proposal was being made “just as we need to take an even more active role in making needed changes in the measurement and reporting system in support of better information for decision making by corporations, investors, and government.” Intense lobbying by the “Big Five” accounting firms defeated the SEC proposal.
Enron
Arthur Andersen began auditing Enron’s books in 1986. By early 2001, Enron had grown into what was widely considered the “premier energy company” involved in wholesale energy trading and marketing, gas transmission, and electric utilities. Its market value of its equity in early 2001 was approximately $75 billion.
In the mid-1990s, Andersen hired Enron’s entire team of 40 internal auditors. It added its own people and opened an office in Enron’s Houston headquarters. With more than 150 people on site, Andersen staff attended Enron meetings and provided input into new businesses and other strategic issues. While the revenues from Enron represented a small fraction of Andersen’s overall revenues, they were a large frac- tion of the Houston office’s revenue and much of the livelihood of the firm’s lead auditor in Houston, David Duncan.
In an attempt to speed up decision making and give local offices more power, Andersen’s once-powerful Professional Standards Group was moved out of the Chicago headquarters and dispersed to local offices. Carl Bass was the PSG member at the Houston office. In 1999, he told Duncan that Enron should take a $30 million to $50 million accounting charge related to a specific transaction. Four months later, Andersen’s management removed Bass from his oversight role at Enron in response to complaints by Enron’s chief accounting officer, who wanted him off the audit. As one former staffer observed, “There were so many people in the Houston office with their fingers in the Enron pie. If they had somebody who said we can’t sign this audit, that person would be fired.”3 This suggests that Andersen’s auditors were aware of the accounting problems at Enron but chose to ignore them.
As 2001 drew to a close, Enron announced that it would take a $544 million after- tax charge against earnings related to its LJM2 Co–investment partnership. It also in- dicated that it would restate its financial statements for 1997–2001 because of ac- counting errors related to it partnerships. The company filed for bankruptcy on December 2, 2001—at that time the biggest bankruptcy filing in U.S. history. Nu- merous scandals relating to excessive compensation and perquisites for top
3N. Byrnes, “Accounting in Crisis,” BusinessWeek, January 28, 2002.
576 Capstone Case Study
executives, accounting fraud, and negligence on the part of Enron’s board quickly followed. Enron’s stock price fell from around $90 per share a year earlier to near zero by the end of 2001. Widespread concern among investors, regulators, and the public arose worldwide. Conflicts of interest apparently had motivated Andersen to sign off on what it knew were questionable accounting practices at Enron.
The Demise of a Once Great Company
Arthur Andersen was subsequently charged with obstructing justice due to the shred- ding of documents and other evidence related to the case. Many outside observers concluded that Andersen staffers had shredded the documents to hide their own roles in producing fraudulent accounting statements. On January 24, 2002, Andersen is- sued the following press release:
While Andersen acknowledges the serious nature of actions and errors made by sev- eral of its Enron engagement employees, it also asks that all concerned be mindful that Andersen is 85,000 honorable, hardworking professionals worldwide—including 28,000 individuals and their families in the United States.
Andersen placed most of the blame on David Duncan, who they claimed had vio- lated the firm’s ethical standards. Andersen quickly fired him.
Arthur Andersen ultimately was found guilty on a felony charge that it had ob- structed the SEC’s investigation of Enron when it shredded important documents and was prohibited from auditing publicly traded companies. The firm discontinued its auditing practice in August 2002. Andersen’s reputation as an independent auditor was destroyed as the facts of its involvement with Enron’s questionable accounting practices came to light. As early as January 2002, after Andersen announced it had shredded Enron documents, but before the federal government issued criminal in- dictments for obstructing justice, Andersen clients began switching independent auditors. In fact, prior to August 2002, the date when Andersen was barred from au- diting public companies because of its conviction for obstructing justice, 690 of its 2,300 public companies had already dropped Andersen as their independent public accountant. To many observers, Andersen’s guilty verdict and eventual liquidation was a sad end for an organization that had once been the largest personal services firm in the world.
As a postscript, the U.S. Supreme Court in May 2005 unanimously overturned Andersen’s guilty verdict in the Enron document shredding case and remanded the case back to a lower court for retrial.4 Yet, by this time Andersen no longer existed as a public accounting firm; 28,000 Andersen employees lost their jobs when Andersen was indicted in June 2002. The federal government has not refiled the original ob- struction of justice charges against Andersen.
Questions 1. Discuss the environmental, strategic, and organizational changes that occurred over the life of Andersen in the context of Figure 11.1.
2. Evaluate Andersen’s claim that their problems on the Enron audit were due to a few “bad part- ners” in the organization. If you disagree with this claim, discuss what you think were the root
causes of the problem.
4B. Mears, “Andersen Conviction Overturned,” Money.cnn.com, May 31, 2005.
Capstone Case Study 577
3. Suppose you were Andersen’s managing partner in the early 1990s. Would you have done any- thing differently than the actual management (assuming you knew only what they did at the
time)? Explain.
4. Discuss the relation between what happened at Andersen and multitask principle agent theory.
5. Discuss the relation between the “hard” and “soft” elements of a firm’s corporate culture in the context of this case.
6. Do you think that the problems at Andersen were unique to them or did they exist at the other big accounting firms? Suppose you were the top partner at one of the other major accounting
firms at that time of Andersen’s demise. What actions, if any, would you take in response?
Explain.
7. In 2000, the SEC proposed new regulations that would limit consulting work by accounting firms. This proposal was not passed by Congress. Do you think that the legislators were trying
to act in the public interest when they failed to pass this proposal? Explain.
8. The American Institute of Certified Public Accountants is the primary professional association for certified public accountants. It has developed a Code of Professional Conduct that sets the standards of conduct for CPAs. People can file complaints about the ethical conduct of a CPA
with the AICPA, which can levy sanctions and other penalties against its members. Do you think
that the unethical conduct at Andersen (and possibly other accounting firms) was the fault of the
AICPA for not setting and enforcing higher ethical standards among its members? Explain.
9. The Sarbanes–Oxley Act of 2002 established a new five-person board to oversee financial ac- counting in publicly traded corporations. The board is appointed by the Securities and Exchange
Commission. Prior to the creation of this board the industry relied primarily on self-regulation
through the American Institute of Certified Public Accountants. Do you think the establishment
of the new oversight board was a good idea or should the profession have continued to be self-
regulated?
chapter
18 C H A P T E R O U T L I N E
Publicly Traded Corporations
Corporate Form of Organization
Stock Exchanges
Stock Ownership Patterns
Governance Objectives
Separation of Ownership and Control
Incentive Issues
Survival of Corporations
Benefits of Publicly Traded Corporations
Top-Level Architecture in U.S. Corporations
Sources of Decision Rights
Shareholders
Board of Directors
Top Management
External Monitors
International Corporate Governance
Market Forces
Sarbanes-Oxley Act of 2002
Corporate Governance: An Historical Perspective
Summary
Web Appendix: Choosing among the Legal Forms of Organization
B ernard “Bernie” Ebbers had worked as a bouncer, milkman, high school basketball coach, and hotel operator. He met with business partners at a coffee shop in Hattiesburg, Mississippi, in 1983 to sketch out an idea for a long-distance telephone company on the
back of a napkin. This legendary meeting resulted in the formation of a com- pany named LDDS (Long Distance Discount Service). The company pur- chased long-distance phone services from AT&T using volume discounts and resold the services to small businesses. Effectively, it took advantage of ATT’s price discrimination strategy. LDDS grew very rapidly through acquisitions and mergers, changing its name to WorldCom in 1995. Its $40 billion acquisition of MCI in 1998 was, at the time, the largest merger in history. By 2000, WorldCom had become a global communications com- pany with $39 billion in annual revenues.
WorldCom was one of the “darlings of Wall Street” during the 1990s with its stock reaching a high of $64.51 in June 1999. CEO Bernie Ebbers owned 27 million shares valued at $1.2 billion in May 2000. His 500,000-acre ranch in British Columbia was the largest working ranch in Canada. Ebbers—with his cowboy boots, colorful background, beard, and informal style—was a folk hero who epitomized the “American Dream.”
L E A R N I N G O B J E C T I V E S
1. Distinguish between closely held and publicly traded corporations. 2. Describe the ownership patterns of large publicly traded corporations in the
United States.
3. List the three key objectives of corporate governance. 4. Discuss the implications of the separation of ownership and control in large
corporations.
5. Discuss the benefits that have contributed to the survival of the corporate form of organization.
6. Define corporate governance as the firm’s high level Organizational Architecture 7. Describe the decision authority and incentives of shareholders, boards of direc-
tors, and top management of large corporations.
8. Describe the role of public accounting firms and other “external” monitors in corporate governance.
9. Discuss key issues in international corporate governance. 10. Explain how market forces contribute to corporate governance.
P A R T F O U R A p p l i c a t i o n s o f O r g a n i z a t i o n a l A r c h i t e c t u r e
Corporate Governance
WorldCom’s growth stalled when the Department of Justice blocked its $129 bil- lion acquisition of Sprint in July 2000. The stock price fell precipitously from that point and by January 2002 was below $10 per share. Ebbers resigned as CEO in April 2002. In June 2002, WorldCom announced that it had understated line costs in past accounting statements by over $3.85 billion. Expenditures that should have been recorded as expenses according to Generally Accepted Accounting Principles (GAAP) had been recorded as assets. The company filed for bankruptcy in July 2002—the largest filing in history. The bankruptcy was followed by an announce- ment that WorldCom’s income had been overstated between 1999 and 2002 by an additional $3.8 billion.
The U.S. Department of Justice charged the top officers of WorldCom with fraud. The chief financial officer and several other managers pleaded guilty and agreed to testify against Ebbers. Ebbers was convicted on nine counts of fraud in 2005 and sentenced to 25 years in jail. Members of the board of directors settled shareholder lawsuits by agreeing to pay over $20 million out of their own pockets. Stock analysts who had touted the stock encountered heavy criticism and legal problems, as did the auditor, Arthur Andersen. “Star” telecom analyst Jack Grubman, who covered WorldCom for Salomon Smith Barney, agreed to pay millions of dollars and accept a permanent bar from the securities industry to settle legal charges. Major investment and commercial banks, such as Citigroup, JPMorgan Chase, ABN Amro (Holland), Tokyo Mitsubishi ( Japan), Goldman Sachs, and UBS (Switzerland), settled lawsuits by agreeing to pay billions of dollars to WorldCom investors for their alleged part in facilitating the fraud.
The collapse of WorldCom, along with other governance scandals (such as Enron, Tyco, Adelphia, and Global Crossing), led many to question whether the U.S. corporate governance system is fatally flawed. In response, Congress passed the Sarbanes-Oxley Act of 2002—the most important corporate disclosure and governance legislation since the 1930s. Subsequent business scandals at interna- tional companies, such as Parmalat (Italy), Royal Ahold (Netherlands), Shell (Netherlands/UK), and SK Global (South Korea), highlighted that corporate gover- nance is a global issue.
Corporate governance is the popular term for describing the organizational ar- chitecture at the top of the firm. Top-level incentives and the partitioning of deci- sion rights among shareholders, the board of directors, top management, and out- side monitors (such as independent auditors and banks) are critically important issues in publicly traded corporations. Corporate governance is a topic that re- quires volumes to cover in depth. This chapter presents a broad overview of cor- porate governance utilizing the organizational architecture framework developed in previous chapters. Our objectives are for the reader to obtain a general under- standing of the key issues in corporate governance and insights into how to design more effective governance systems. The chapter also offers insights into the causes and implications of contemporary governance scandals and the effects of the Sarbanes-Oxley Act of 2002.
The remainder of this chapter is organized as follows. The first section describes the basic attributes and governance concerns of publicly traded corporations. The second section provides an overview of the U.S. corporate governance system (top- level organizational architecture)—focusing specific attention on the decision au- thority and incentives of shareholders, the board of directors, top management, and outside monitors (such as the independent auditors). The remaining sections exam- ine governance from an international perspective, the role of market forces in the
Chapter 18 Corporate Governance 579
580 Part 4 Applications of Organizational Architecture
governance process, the Sarbanes-Oxley Act of 2002, and corporate governance from a historical perspective. The chapter concludes with a summary. The Web Ap- pendix to this chapter (available via McGraw-Hill Connect) presents an economic analysis of the more fundamental choice of organizing as a corporation versus other legal alternatives.
Publicly Traded Corporations Important examples of alternative legal forms of organization include corporations, individual proprietorships, partnerships, and nonprofit organizations. Corporations are the most important form of organization in terms of employment and sales. The 1997 Economic Census reports that corporations were responsible for 91 percent of the total sales in the United States and 89 percent of the total employment. Much of this activity occurred in large publicly traded corporations, such as General Electric and Walmart.
This chapter focuses on governance in large publicly traded corporations. The Web Appendix to this chapter (available via McGraw-Hill Connect) discusses the important economic factors that drive the choice among the broader set of organizational alternatives, such as profit versus nonprofit status, single proprietor- ships, and public versus private corporations.
Corporate Form of Organization
Corporations are formed by filing the appropriate paperwork with and paying fees to officials in the state of incorporation. Corporations have the legal standing of an in- dividual (distinct from its shareholders) and can enter into contracts and participate in lawsuits. Corporations have the right to issue stock and to exist indefinitely. State laws require corporations to have a board of directors that is assigned the primary de- cision control rights for the firm. Shareholders have the rights to vote on certain “fun- damental” issues and in the election of the board.1 In the United States, boards have a fiduciary responsibility to represent the interests of the corporation and its share- holders. Corporations are free to select their boards and governance procedures (for instance, voting rules) within the legal boundaries. Shareholders have limited liabil- ity (only their initial capital contribution is subject to risk and they usually are not legally responsible for the debts of the corporation).
Some corporations are closely held, while others are publicly traded. Closely held corporations are characterized by stock that is not freely traded and often held by only a few shareholders (often within the same family). While many closely held corporations are small, some are very large. In 2004, the three largest were Cargill, Koch Industries, and Mars with annual sales of $66.7 billion, $60 billion, and $19.1 billion, respectively. Publicly traded corporations are characterized by stock that is sold to and traded among the general public. Examples include Walmart, General Electric, Coca Cola, Microsoft, Daimler Benz (German), Royal Dutch/Shell Group (UK), and Toyota Motor ( Japan). (See the Web appendix to this chapter for an analysis of the trade-offs between closely held and publicly traded firms).
1Common stock holders own title to the residual profits of the firm. While most stock in the United States is common stock, some firms also issue preferred stock. The dividends paid on preferred stock are fixed and “guaranteed.” Our discussion focuses on common stockholders.
Chapter 18 Corporate Governance 581
Stock Exchanges
Publicly traded companies often are listed on organized stock exchanges. The largest exchange in the world is the New York Stock Exchange (NYSE), which provides an extremely active and liquid market for trading shares. In 2005, there were nearly 2,800 companies listed on the NYSE with an aggregate market value of over $20 tril- lion.2 Prominent international stock exchanges include the Tokyo Stock Exchange, London Stock Exchange, and Euronext with combined domestic equity capitalization at year-end 2004 of nearly $9 trillion.3 In 2005, 54 regulated exchanges from around the world were members of the World Federation of Stock Exchanges (a trade associ- ation jointly accounting for over 97 percent of the world stock market capitalization).
Stock Ownership Patterns
Institutional stock ownership (e.g., by mutual funds) increased dramatically in the United States during the second half of the twentieth century. In 1950, individual households owned over 90 percent of the publicly traded stock in the United States, while pension funds and other institutional investors owned only about 7 percent. By 2000, institutional investors owned over 50 percent of the stock—mutual funds owned an estimated $3.6 trillion of stock, followed by private pension funds, state and local pension funds, and life insurance companies with $2.5 trillion, $2.0 trillion, and $1.0 trillion, respectively.
While the typical large firm has thousands of “small” shareholders, many have blockholders that own a nontrivial fraction of the shares. Studies document that the top five shareholders in the typical publicly traded U.S. corporation own about 25 percent of the shares, while the top 20 shareholders own over 35 percent.4 For descriptive purposes, we define a widely held corporation as one in which no one owner controls more than 10 percent of the shares. In 1995, 80 percent of the 20 largest firms and 50 percent of the “medium-sized” firms in the United States were widely held. In most of the remaining firms the dominant blockholder con- trolled less than 20 percent of the shares.5
The frequency of widely held corporations is lower in many other countries. Ex- amples based on the largest 20 firms in the country in 1995 include Japan (50 per- cent), Switzerland (50 percent), Germany (35 percent), France (30 percent), Italy (15 percent), New Zealand (5 percent), Singapore (5 percent), Mexico (0 percent), and Portugal (0 percent). Similar cross-country patterns hold for medium-sized firms. Block ownership by families, the state, and banks is more prominent in other coun- tries than in the United States. The relatively high frequency of widely held corpora- tions in the United States is partially explained by the country’s well-developed stock markets and legal system that help to protect the interests of small shareholders. Also, regulation historically restricted bank stock ownership in the United States. As discussed later in this chapter, differences in stock ownership across countries give rise to somewhat different types of governance problems.
2Data are from the NYSE Web site (www.nyse.com) and the NASDAQ Web site (www.nasdaq.com). 3Data are from the Annual Report of the World Federation of Stock Exchanges, May 9, 2005. 4See H. Demsetz and K. Lehn (1985), “The Structure of Corporate Ownership: Causes and Consequences,”
Journal of Political Economy 93, 1155–1177. 5See R. La Porta, F. Lopez-de-Silanes, and A. Shliefer (1999), “Corporate Ownership Around the World,”
Journal of Finance 54, 471–515.
582 Part 4 Applications of Organizational Architecture
Governance Objectives
As stated earlier, corporate governance is the popular term, which is used to describe organizational architecture at the top of a corporation. Corporate governance focuses on the allocation of decision rights among the shareholders, board of directors, top managers, and various external monitors (e.g., independent auditors, stock ex- changes, governmental regulators, and financial analysts) and the associated incen- tives of these parties. Corporate governance also encompasses the type and fre- quency of information corporations must disclose to various constituents. Alternative governance systems often are evaluated based on three key objectives that relate to value creation and the survival of corporations:
1. The motivation of value-maximizing decisions. 2. The protection of assets from unauthorized acquisition, use, or disposition. 3. The production of proper financial statements that meet the legal requirements.
Separation of Ownership and Control
Incentive Issues
We have discussed how alienable private property rights, along with free markets, promote the collocation of decision rights and knowledge and provide incentives for productive actions. The analysis considered the case where asset ownership and deci- sion-making authority are held by the same person. If Bob Hayek owns a farm, he has incentives to grow the most valuable crops since he bears the negative wealth effects of growing something else. If Alice Coase knows how to use the land more produc- tively, there are likely to be gains from trade if Bob sells the land to Alice.
Much of the stock of large publicly traded corporations is held by diversified in- vestors who take little interest in the governance of individual firms. Operational control of large corporations is delegated to professional managers and overseen by a board of directors who have limited financial interests in the firm. Thus, in contrast to the analysis in Chapter 3, there is separation of ownership and control. This sep- aration implies that corporate decision makers have weaker incentives to use assets productively than in small businesses where ownership and control are held by the same person. Managers also have weaker incentives than owners to transfer control of the corporation to more informed management teams. (Chapter 10 provides a more detailed discussion of incentive conflicts that arise in corporations between the shareholders and managers, as well as among other contracting parties in the firm.)
Concerns about the separation of ownership and control have led some scholars to question the social and productive efficiency of the corporate form of organization. For example, legal scholars Adolf Berle and Gardiner Means, in their influential 1933 book The Modern Corporation and Private Property, argue that widely held corporations will be run inefficiently by professional managers.6 More recently Michael Jensen argued that the public corporation was being “eclipsed” by more ef- ficient forms of organization that have concentrated managerial stock ownership.7 The
6A. Berle, Jr. and G. Means (1933), The Modern Corporation and Private Property (MacMillan: New York), 8–9. 7M. Jensen (1989), “Eclipse of the Public Corporation,” Harvard Business Review (September), 61–74.
Chapter 18 Corporate Governance 583
2001–2002 governance scandals generated public concerns about whether managers run corporations primarily for their own benefit (e.g., to receive “excess” compensa- tion and perquisites). WorldCom and other prominent firms had failed to meet all three objectives of corporate governance (motivation of value-maximizing decisions, protection of assets, and production of proper financial statements).
Survival of Corporations
In spite of these concerns, large publicly traded corporations have accounted for most of the free worlds’ industrial output for decades. The principle of Economic Darwinism implies that publicly traded corporations have economic advantages in many business settings. Otherwise publicly traded corporations would have been re- placed by more efficient organizational alternatives through the competitive process.
Critics have been particularly vocal about the governance of U.S. firms as evi- denced by widespread criticisms of executive compensation and perquisites. Given the intensity of this criticism, one would think that the U.S. stock market must have performed very poorly. This, however, has not been the case.8 Over the past 80 years U.S. stocks experienced average annual returns of about 10 percent. While U.S. stocks fell dramatically between 2001 and 2003 in the wake of the dot-com–telecom bust and corporate scandals, they experienced relatively high returns between 2003 and 2005. While stock returns are determined by many factors besides corporate governance, the data suggest that corporate governance has not placed U.S. compa- nies at a significant competitive disadvantage.
Economic Darwinism implies that international governance systems will tend to converge with increased global competition if some governance features are inher- ently superior to others. As discussed below, there has been some international movement toward the U.S. corporate governance system.
Benefits of Publicly Traded Corporations
Since the separation of ownership and control generates costs relative to combined ownership and control there must be offsetting benefits to explain the existence of large corporations. Firms often can reduce the costs of raising equity capital by sell- ing stock to diversified investors in public capital markets. Risk-averse individuals must be compensated for bearing risk to entice them to invest in a firm. Investors demand compensation only for a portion of the total risk associated with a given corporation’s cash flows, since some of the risk is eliminated by holding the investment in a diversified portfolio. Raising capital from diversified investors is par- ticularly important for large firms that require significant funds to finance invest- ment, and is the primary reason why most large firms are organized as publicly traded corporations. For example, Google and UPS recently went public raising bil- lions of dollars of equity capital. Public corporations also benefit from not having to restrict the supply of top managers to people who are rich enough to buy large firms.
The widespread existence of corporations suggests that the net benefits of the corporate form of organization must be positive in many environments. This
8See B. Holmstrom and S. Kaplan (2003), “The State of U.S. Corporate Governance: What’s Right and What’s
Wrong?” Journal of Applied Corporate Finance 15 (3), 8–20.
584 Part 4 Applications of Organizational Architecture
observation implies that it is possible to design cost-effective governance systems (top-level architectures) to address the incentive problems that arise from the separa- tion of ownership and control. Since surviving organizational architectures are optimal in a relative versus an absolute sense—that is, they are the best among the competition—there is always the possibility that governance might be improved through time as value-enhancing innovations are discovered and implemented.
Top-Level Architecture in U.S. Corporations In contrast to popular perception, the organizational architecture of the typical cor- poration in the United States does not give absolute authority to professional man- agers. Rather, decision rights are divided among shareholders, the board of directors, top management, and external monitors (e.g., the independent auditors and lenders) in a manner that attempts to separate decision control (ratification and monitoring of a decision) from decision management (initiation and implementation of a decision). This separation is critical when, as in the publicly traded corporation, decision makers do not bear the full wealth effect of their actions. Consistent with Chapters 15–17, corporations also attempt to foster productive decisions among top-level decision makers through performance-based compensation and other incentive and control mechanisms.
Adam Smith—Right about Markets; Wrong about Firms Adam Smith (1723–1790) was a famous Scottish philosopher and economist. His influential book The Wealth of Nations (1776) presented the economic underpinnings of free markets and played a huge role in popularizing laissez- faire economic policies. Smith understood that publicly traded corporations (known as joint stock companies in this
day) had an advantage in raising capital. In The Wealth of Nations he wrote:
This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. The trading stock of the South Sea Company, at one time, amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds.
Nevertheless, Smith argued that agency problems would destroy joint stock companies (unless they were assisted by the
government).
The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers.
Smith failed to foresee how a well-designed organizational architecture can help to control agency problems in the
publicly traded corporation. He would not have been surprised by WorldCom, Parmalat, or other corporate scandals. He
would have been surprised that these types of scandals are the exception, rather than the rule.
Source: A. Smith (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Goldmiths’-Kress Library of Economic Literature, no. 11392.
A C A D E M I C A P P L I C AT I O N S
Chapter 18 Corporate Governance 585
This section begins with a discussion of the sources of decision authority at the top of the corporation. Subsequently, we present a more detailed examination of the decision-making authority and incentives of shareholders, the board of directors, top management, and outside monitors.
Sources of Decision Rights
Top-level authority in corporations is divided among shareholders, the board of directors, and top management. Other groups that can have roles in the decision- making process include bondholders, preferred stockholders, lenders, independent auditors, and stock/credit analysts. The allocation of decision rights at the top of the firm is determined by law/regulation and voluntary choices, such as signing an agreement that grants specific decision rights to the contracting parties. This section provides a brief discussion of these “sources” of top-level decision rights.
Incorporation occurs at the state, not the federal, level in the United States. Examples of state laws that affect the partitioning of decision rights include require- ments relating to the size of the board of directors and restrictions on shareholder voting. For instance, some states allow firms to use cumulative voting in the election of directors, while other states do not. (Cumulative voting allows a large minority shareholder to elect some directors even if their election is opposed by the majority of shareholders.)
The allocation of decision rights also is affected by federal laws and regulations. For example, the Securities Exchange Commission (SEC), which regulates the U.S.
ANALYZING MANAGERIAL DECISIONS: CEO Pay in Public and Private Firms
Numerous firms including Hertz, Bausch & Lomb,
HCA, Clear Channel, and J. Crew have exited the
public capital market via going-private transactions.
In these deals a private equity firm such as Kohlberg
Kravis Roberts & Co. (KKR) or The Carlyle Group
puts up a modest amount of the equity (usually from
large private investors and institutions) and borrows
the rest from banks. These funds then buy out the
public shareholders; the new owner is the private
equity firm who either retains the current managers
or replaces them. For example, KKR bought VNU,
a $4.3 billion media company, and hired David
Calhoun, who had been running General Electric’s
(GE) $47 billion aircraft unit. Mr. Calhoun’s pay
package at VNU was worth more than $100 million,
many times more than his GE compensation.
Or, consider the case of Millard Drexler who
was hired to turn around J. Crew after a successful
16-year career at running Gap. His annual J. Crew
salary was $200,000 and no bonus. He also was
granted millions of shares of stock, which at the
time were not being traded. After J. Crew again be-
came a public company, Mr. Drexler’s ownership in
J. Crew was worth over $300 million. In fact, it is
often the case that executives earn more money
running privately held firms than public companies,
and they do not have to deal with unruly sharehold-
ers claiming they are overpaid.
1. Explain why executives might be paid more to
run private companies than these same compa-
nies would have paid their executives when
they were public.
2. What might these employment packages have
to say about the argument that public company
executives are overpaid?
SOURCE: A. Sorkin and E. Dash (2007), “Private Firms Lure C.E.O.s with Top Pay,” The New York Times (January 8).
586 Part 4 Applications of Organizational Architecture
securities industry, recently debated new rules that would give large shareholders limited rights to nominate board members through the normal proxy process. Nom- inations currently are made by the existing board of directors (unless there is a proxy fight). The Sarbanes-Oxley Act of 2002 affects decision rights, for example, by re- stricting corporate interactions with public accounting firms. It also assigns respon- sibility to the chief executive officer and the chief financial officer to certify the cor- poration’s financial statements and the effectiveness of internal controls over the financial reports. Criminal penalties exist for violations of the law.
Laws are interpreted through court decisions, which also can have important ef- fects on the assignment of corporate decision rights. For example, Delaware courts (where many firms are incorporated) have established legal precedents that generally emphasize directors’ fiduciary responsibilities to stockholders in takeover contests (as opposed to the interests of other parties, such as employees).
International corporations are affected by the laws and regulations in their own countries. For instance, supervisory boards in German corporations must contain employee representatives.
The firm can be viewed as a focal point for a set of contracts (see Chapter 10). The firm is always one party to the many contracts that make up the firm. Examples in- clude employee contracts, supplier agreements, loans, bonds, and stocks. Contracts frequently contain provisions that assign specific decision rights to the contracting parties. The contractual rights of shareholders are largely specified in the corporate charter and bylaws. For example, when allowed by law, some corporations adopt char- ter or bylaw provisions that require a supermajority of shareholder votes (more than 50 percent) to approve a merger, while other firms require only a simple majority. The charter and bylaws specify such things as board size, shareholder meeting proce- dures, and quorum requirements, as well as the general responsibilities of the board, its committees, and top management. Contracts with preferred stockholders can in- clude provisions that allow the affected security holders to participate in the election of directors when preferred stock dividends are in arrears.
When a corporation lists its stock on an exchange it agrees to comply with the rules of the exchange. Stock exchanges often require member firms to have specific governance provisions. In the aftermath of WorldCom and other corporate scandals, the NYSE began requiring member firms to have a board of directors consisting of a majority of “independent” directors. Member firms are also required to have inde- pendent audit, governance, and compensation committees (consisting entirely of in- dependent directors). Similar rules were adopted by NASDAQ. Foreign exchanges also often have governance requirements. For example, the Italian stock exchange adopted a “code of conduct” in 1999 in an attempt to improve corporate governance among Italian firms. Most stock exchanges also require minimum disclosure rules for financial information; such disclosures presumably allow external shareholders to better monitor management.
Shareholders
Decision Authority of Shareholders While shareholders traditionally are viewed as the ultimate owners of the corporation, they have only limited powers to participate in the management of the company. Shareholders have the right to vote in the election of directors, but the board has primary authority for managing the firm. Shareholders also often vote to ratify the
Chapter 18 Corporate Governance 587
independent auditors and on “fundamental” issues, such as changes in the articles of incorporation (part of their contract with the corporation) and significant proposals that are not in the regular course of business (e.g., large mergers, the issuance of additional shares, equity-based compensation plans, and the dissolution of the corporation).
Prior to shareholder meetings, managers furnish shareholders with proxy state- ments that contain information, much of which is specified by the SEC. Managers (with board approval) make recommendations on voting issues and ask for the share- holders’ proxies to vote their shares. In most elections, management obtains enough votes to pass their proposals and elect their recommended slate of candidates for the board. On rare occasions, a dissident shareholder who is unhappy with the current management’s performance will wage a “proxy contest” and solicit votes to elect board members that are not supported by management. Academic research suggests that this proxy process imposes constraints on management that help to increase share value.9 For example, share prices increase significantly around proxy contests; subsequent to proxy fights firms often make operational changes or are taken over, even if the dissidents fail to elect their proposed board members. Sometimes man- agement will make operational changes to avoid a proxy fight.
While each shareholder normally has one vote for each share held, this is not always the case. Some firms have dual-class voting shares, where one class of stock has the primary claim to the residual profits and few voting rights, while the other class has a smaller claim to the residual profits but retains more of the voting rights. Jointly locat- ing voting control and residual-claim rights usually is optimal since it gives those with ultimate control the incentives to maximize value and facilitates the efficient transfer of control among the shareholders.10 Nonetheless, it sometimes can be efficient to issue shares with limited voting rights. One example arises when the private benefits of control (frequently nonpecuniary) are sufficiently large to offset the agency costs asso- ciated with separating control and residual-claim rights. For example, a founder who values control might issue shares with limited voting rights, even if shares with full voting rights would command a higher price.11 Increased voting control also can pro- vide management with incentives to invest in organizational-specific human capital.12
While shareholders of U.S. firms have ratification rights for major proposals initiated by the board, they do not have significant authority to initiate corporate ac- tions. Shareholders can make recommendations to the board, for example, on exec- utive compensation and corporate governance. However, U.S. boards have no legal obligation to adopt these proposals even if they receive substantial support in shareholder voting. For example, from 1997 through 2003 there were at least 131 shareholder resolutions to do away with staggered boards that passed by a
9For a summary of the academic literature on this topic, see J. F. Weston, M. L. Mitchell, and J. H. Mulherin
(2004), Takeovers, Restructuring and Corporate Governance, 4th edition (Prentice Hall: Upper Saddle River).
10See S. Grossman and O. Hart (1988), “One Share- One Vote and the Market for Corporate Control,” Journal of Financial Economics 20, 175–202; and M. Harris and A. Raviv (1988), “Corporate Governance: Voting Rights and Majority Rules,” Journal of Financial Economics 20, 203–235.
11Evidence suggests that the typical limited voting right stock sells at a discount of over 5 percent relative
to its superior voting right counterpart. Thus if a founder decides to go public with a limited voting rights
stock issue, he might expect to sell it at a discount relative to what he would receive for a full voting
right stock issue of similar size. See R. Lease, J. McConnell, and W. Mikkelson (1983), “The Market Value
of Control in Publicly traded Corporations,” Journal of Financial Economics 11, 439–471. 12For example, see R. Stulz (1988), “Managerial Control of Voting Rights: Financing Policies and the Market
for Corporate Control,” Journal of Financial Economics 20, 25–54.
588 Part 4 Applications of Organizational Architecture
majority vote in U.S. corporations.13 As of fall 2004, 69 percent of the companies had not implemented the proposal. Shareholders in the United Kingdom have more legal authority than in the United States. For example, U.K. shareholders can pro- pose changes to the articles of incorporation and any corporate decision. The board must adopt a shareholder proposal if it receives more than 75 percent of the votes cast
ANALYZING MANAGERIAL DECISIONS: Sotheby’s Holdings—The Sting of the “Killer B” Stocks
Christie’s International PLC and Sotheby’s Hold-
ings are the two largest fine arts auction houses in
the world. In January 2000, the announcement that
Christie’s had agreed to cooperate with the U.S.
Justice Department in its investigation of price fix-
ing sent Sotheby’s stock down $3.50 per share (or
15 percent) to $20.50. In return for amnesty,
Christie’s admitted that it had conspired with
Sotheby’s to fix auction commissions. Price fixing
is illegal under American and European antitrust
laws. Ultimately, lawsuits were settled for hundreds
of millions of dollars and Sotheby’s chairman,
Alfred Taubman, was sentenced to a jail term and a
$7.5 million fine.
Prior to the price-fixing scandal, Sotheby’s had
two classes of common stock. Each of the
42,269,201 Class A shares was entitled to one vote,
while each of the 16,585,650 Class B shares was
entitled to 10 votes. Taubman, who owned much
of the Class B stock (known as “killer B’s”),
controlled the company with 62.5 percent of the
voting rights but had only 23 percent of the cash-flow
rights. Baron Capital Group (headed by Ron Baron)
in contrast was entitled to 40 percent of the cash
flows, but had only 11 percent of the voting rights.
Prior to the scandal becoming public, Ron Baron
indicated that he had significant faith in Taubman’s
leadership and was not concerned about
Taubman’s control through his ownership of the
“killer B” stock. After the scandal became public
and the stock price fell, significant conflict arose
between Baron and Taubman. Baron wanted
Taubman and his son to leave the company. Baron
feared that Taubman’s incentives were no longer
aligned with the company and its shareholders, and
that he might use company funds in an unreason-
able legal settlement to protect himself from prose-
cution. The Taubmans refused to give up control,
and Baron did not have enough votes to force them
to leave. In a screaming match with Baron, son
Robert Taubman announced that his family had no
intention of giving up control of their company.
Ultimately the conflict was resolved. However,
this example illustrates the conflicts that can arise
when there is a separation of ownership and control
rights. The Taubmans would have been forced to
give up control of the company more quickly if, as in
the typical company, their claim for 23 percent of the
cash flows was associated with 23 percent of the vot-
ing rights. (Note that this conflict does not imply that
it necessarily was suboptimal for Sotheby’s to issue
dual-class shares when they originally were sold. But
it does illustrate vividly some of the costs associated
with dual-class shares that can arise after the fact.)
The governance structure at Sotheby’s appeared
to give Taubman absolute control. Nevertheless the
company was able to resolve the antitrust problem
relatively quickly without significant opportunism
by Taubman. Ultimately, this resolution helped to
limit the losses to minority shareholders.
What forces and incentive mechanisms helped
this settlement come to pass?
SOURCE: S. Tully (2000), “Sotheby’s: A House Divided,” Fortune (December 18), 264–273.
13The data are from L. Bebchuk (2005), “The Case for Increasing Shareholder Power,” Harvard Law Review 188, 854. The terms staggered board and classified board are synonymous. An example of such a board is as follows. The company has nine directors who are divided into three classes. Board members serve three-
year terms. In any given year, only one class comes up for election. Opponents of classified boards argue that
they harm shareholders because they increase the time it takes to accomplish hostile takeovers (a majority of
the board does not come up for election in a given year). Others argue that staggered boards are good since
they help to assure that there are always experienced people on the board.
Chapter 18 Corporate Governance 589
at the meeting. Some commentators argue that shareholders should be given additional legal authority in the United States.14 Others argue that most shareholders do not have detailed specific knowledge about the firms in their portfolios. Many also lack incen- tives to be involved in the governance process. Therefore, it is potentially more efficient to have shareholders delegate primary decision-making authority to an elected board of directors who can become appropriately informed on specific issues at lower cost.15
Giving additional rights to shareholders could complicate the proxy process and allow special interest groups to impose costs on the firm and its shareholders. In the aftermath of the Enron and WorldCom scandals, debate continues among the SEC and other in- terested parties about whether laws and regulations should be changed to give share- holders more decision rights. While corporations have some ability to amend their own charters and bylaws to increase shareholder rights, they face some legal constraints under existing laws and regulations.16
M A N A G E R I A L A P P L I C AT I O N S
Charles Schwab Corporation Refuses to Include Shareholder Proposal in Proxy Statement The corporate bylaws or charter often give shareholders the right to vote on the ratification of auditors. Shareholders,
however, do not have this right in all firms.
On November 23, 2004, the Sheet Metal Worker’s National Pension Fund requested that the Charles Schwab
Corporation place the following shareholder proposal in their 2005 proxy statement:
Resolved: That the shareholders of Charles Schwab (the “Company”) request that the Board of Directors and its Audit Committee adopt a policy that the selection of the Company’s independent auditor be submitted to the Company’s shareholders for their ratification at the Company’s annual meeting.
Corporate legal counsel advised that Schwab did not have to comply with this request. The SEC rule on shareholder
proposals allows companies to exclude a proposal by a stockholder if it “deals with a matter relating to the company’s
ordinary business operations.” The SEC had affirmed in several previous cases that proposals relating to the selection
of auditors could be excluded on this criterion. According to Schwab’s legal counsel:
The responsibility for selecting the independent auditors rests with the Company’s Audit Committee of the Board of Directors. The Company is incorporated under the laws of the State of Delaware. Section 141(a) of the Delaware General Corporation Law (the “DGCL”) provides that the “business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”
On February 23, 2005, the SEC’s Office of Chief Counsel Division of Corporation Finance wrote the corporation a
letter. The letter affirmed that Schwab’s legal counsel had “some basis” for the view that the company could exclude
the proposal. The SEC staff stated that they would “not recommend enforcement action to the Commission if Charles
Schwab omits the proposal from its proxy materials in reliance on rule 14a-8(i)(7).”
This example highlights that while shareholders might be viewed as the ultimate owners of the corporation, they
have only limited powers to participate in the management of the company. Primary authority for managing the
company is delegated by the shareholders to the board of directors.
Source: SEC and corporate documents provided by Robert Oppenheimer, Esq.
14See L. Bebchuk (2005), “The Case for Increasing Shareholder Power,” Harvard Law Review 188, 833–914; and L. Bebchuck and J. Fried (2004), Pay without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press: Cambridge).
15See F. Easterbrook and D. Fischel (1991), The Economic Structure of Corporate Law (Harvard University Press: Cambridge), 87–88.
16See L. Bebchuk (2005), “The Case for Increasing Shareholder Power,” Harvard Law Review 118, 888–891.
590 Part 4 Applications of Organizational Architecture
Common law countries such as the United States and the United Kingdom tend to provide stronger legal protection to shareholders than French civil law countries, such as France, Italy, Indonesia, and Brazil.17 Common law countries also tend to have more active securities markets, less corrupt governments, more efficient courts, and better financial disclosure than many other countries. Research suggests that sound legal and financial markets have helped the United States and certain other common law countries to achieve high economic growth rates.18 An important counterexample is China that has grown rapidly despite its poor legal and financial systems.19 In China, reputation and relationships among the contracting parties appear to substitute for more formal legal protections. Understanding the links among shareholder protection, financial markets, and growth continues to be an active area of academic research.
Shareholder Incentives Shareholders can be divided into three basic types: Small shareholders, institutional investors, and large blockholders. All shareholders benefit from increases in share value. However, they vary in their incentives to participate in the governance process and in countervailing incentives that can motivate actions that are inconsistent with maximizing the value of the shares.
Small shareholders do not have incentives to take an active role in the governance process (unless they get consumption value from the activity). If Maria Cruz owns 100 shares of stock in a large company, she is unlikely to have the power to influence the direction of the corporation or its management. Even if she could take actions that increase share price, most of the gains would go to other shareholders. While it is in the collective interests for small shareholders to be involved in the governance process, from Maria’s viewpoint it is rational to free ride on the efforts of others. Consistent with this argument, small shareholders vote less frequently in corporate elections than blockholders.
Institutional investors (e.g., pension funds, insurance companies, actively man- aged mutual funds, index funds, and trusts) hold the majority of shares of large U.S. corporations. Institutional investors tend to be more informed about governance is- sues than most small shareholders and are more likely to vote their shares due to legal obligations and other concerns. Yet, institutional investors have been criticized for not taking a more active role in corporate governance. Critics correctly argue that institutional investors that fear loss of other business with the company (such as in- surance companies) have incentives not to challenge management actions.20 The
17Legal traditions vary around the world. There are two broad classifications: Civil law and common law.
Legislation is the primary source of law in civil law countries, while the primary sources of law in common
law countries are legal precedents set by the courts. Civil law countries are frequently divided into three
groups: French, German, and Scandinavian. Dutch civil law is not easily placed in one of the three
categories. The Russian civil code is based partly on a translation of the Dutch code. There is some
ambiguity in classifying specific country legal systems. For example, the legal systems in Portugal and Italy
evolved from both French and German influence. The major legal traditions were developed in Europe and
spread throughout the world through colonization. The legal systems in Japan, China, and South Korea were
most influenced by German civil law. Research indicates that French civil law countries tend to be the
weakest in terms of shareholder protections, efficient/fair court systems, and corporate disclosure. 18Surveying the large body of research on this topic is beyond the scope of this book. A good starting point is
the work of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny. 19See F. Allen, J. Qian, and M. Qian (2005), “Law, Finance, and Economic Growth in China,” Journal of
Financial Economics 77, 57–116. 20See J. Brickley, R. Lease, and C. Smith (1988), “Ownership Structure and Voting on Antitakeover
Amendments,” Journal of Financial Economics 20, 267–291, for evidence that other business interests affect the voting behavior of institutional investors.
Chapter 18 Corporate Governance 591
most active institutions have been public pension funds (for instance, TIAA-CREF, Hermes, and CalPERS), which are relatively insensitive to management pressures. There is some evidence that institutional investors have become more active in the governance process in the post-WorldCom environment (e.g., in challenging execu- tive compensation and the accounting for options).
Blockholders have stronger incentives to participate in the governance process than small shareholders since they internalize more of the benefits and have more power to effect corporate behavior. Small shareholders benefit when blockholders take actions to increase share value. Blockholder and small shareholder interests can conflict when the blockholder is able to extract “private benefits” from the firm. For example, Joaquin Rodriquez, CEO of the Green Food Company, might use his 20 percent ownership to block an outside takeover so that he can continue to obtain excess compensation and perquisites. Empirical research suggests that managerial stock ownership might have both positive and negative effects on share value depending on the level of ownership. Negative effects (if they exist) appear most likely in intermediate ranges of ownership (e.g., when the managers own be- tween 5 and 20 percent of the stock).21 It is within this range that managers are most likely to have both the ability and incentive to “entrench” themselves against value-increasing takeovers. They do not have the power at lower levels of owner- ship; they do not have the incentives at higher levels of ownership (since they bear much of the negative wealth effect).
Board of Directors
Authority of the Board While the board of directors has primary legal authority for managing the firm, the typical board delegates much of this authority to professional managers. Consistent with the organizational architecture framework, the board’s primary function is top- level decision control—general oversight of the corporation and ratification of important decisions. It is not to micromanage the firm. Among the board’s most im- portant charges are to monitor, compensate, and when necessary replace the CEO. Significant strategic and investment decisions generally have to be authorized by specific board resolutions. For example, large firms have capital expenditure
ANALYZING MANAGERIAL DECISIONS: Stock Market Reactions to 13D Filings
An investor must file a 13D form upon accu-
mulation of 5 percent of the stock of a publicly
traded company. Typically the stock market re-
acts quite favorably to these announcements.
But outside block ownership has both costs and
benefits.
1. Provide a brief description of these costs and
benefits.
2. Does the evidence on the stock market reac-
tions to 13D filings suggest that the benefits of
outside block ownership are typically larger
than the costs? Explain.
21R. Morck, A. Shleifer, and R. Vishny (1988), “Management Ownership and Market Valuation: An Empirical
Analysis,” Journal of Financial Economics 20, 293–315.
592 Part 4 Applications of Organizational Architecture
approval processes that require board votes for large projects. Board members also provide input and advice to managers on business decisions based on their own past experiences and expertise.
In the United States, board members have a fiduciary responsibility to represent the interests of the corporation and its shareholders. Specific fiduciary duties include good faith, reasonable care, and loyalty (avoiding self-serving actions against the in- terests of the corporation). Board members are given broad legal protection under the business judgment rule. Board members generally avoid legal liability even for dis- astrous business outcomes if they take reasonable care to make business decisions that they believe are in the best interests of the corporation. This legal precedent avoids placing judges and/or juries in the position to have to “second guess” business decisions after the fact. Corporations also provide insurance coverage to directors to protect them against lawsuits. It would be difficult to attract qualified board members without this coverage. The multimillion dollar legal settlements by directors at WorldCom and Enron announced in 2005 are among the first major out-of-pocket settlements made by U.S. directors.
The typical corporate board in the United States has about 12 members; over half of these members are outside directors (not existing managers or their family mem- bers). However, there is substantial variation in board size and composition across firms. For example, boards ranged in size from 4 to 33 among Fortune 1000 firms in 1999. The CEO almost always is on the board and in about 80 percent of U.S. firms serves as the chairman of the board. The typical board has one or two other top man- agers (e.g., the president, chief operating officer, and or chief financial officer). The typical board meets seven to eight times per year in regular session, along with any special meetings.
Efficiency dictates that much of the work of the board be conducted by commit- tees. Committee reports and recommendations are discussed at the full board meet- ing where voting takes place. Most firms have audit, compensation, nominating, and executive (empowered to make various decisions between board meetings) commit- tees. Other committees, such as a finance committee, are found in many firms.
The audit committee has top-level responsibility for monitoring the firm’s finan- cial reporting, ethics, and control systems. WorldCom and other accounting scandals have highlighted the importance of this committee. The Sarbanes-Oxley Act of 2002 requires that independent auditors report critical accounting issues and disputes be- tween the independent accountant and management to the audit committee. It also places composition and procedural requirements on audit committees. Many firms have increased the compensation of the chair of the audit committee due to the in- creased workload in the Sarbanes-Oxley environment.
Some researchers argue that firm value decreases systematically with the size of the board.22 They view small boards as superior because they are potentially less po- litical and have fewer free-rider problems and coordination costs than large boards. The current business and regulatory environment, however, places a practical lower- bound on board size. NYSE firms must have independent audit, nominating, and compensation committees. Thus, they must have at least six outside directors on the board if the committees are to have four members and no one individual is to serve on more than two committees. In addition, the typical firm is likely to want to place outside directors on the executive and other committees.
22See D. Yermack (1996), “Higher Market Valuation for Companies with a Small Board of Directors,” Journal of Financial Economics 40, 185–211.
Chapter 18 Corporate Governance 593
Our organizational architecture framework suggests that the optimal size, compo- sition, committee structure, and processes of the board are likely to vary with the firm’s environment and strategy. For example, a firm in the defense industry might create a committee focusing on government relations, while a firm in the retail sec- tor would not. The differences in committee structure could generate differences in both the optimal size and composition of the board. Consistent with this view, board composition, structure, and processes vary significantly across firms and through time—no one design is optimal for all firms. A good starting point for analyzing board design is to benchmark firms with similar environments and strategies.
According to some commentators, good board members act as skeptics who care- fully scrutinize and question the managers’ actions and proposals. Independence and separation between the board and management is stressed. It is important to recognize, however, that well-functioning boards do more than simply monitor managers. Board members can also be among the CEO’s most trusted colleagues and advisors. They have specific knowledge about the firm and often have experiences and skills that com- plement the CEO. While it is important for board members to take their monitoring and oversight roles seriously, it is likely to be undesirable for the board and the CEO to have an adversarial relationship. Conversely, a harmonious relationship between a CEO and board does not imply that the board is failing in its decision control function.
Board Member Incentives Outside directors typically own limited amounts of stock in the firm. For example, one study found that half of the directors in their sample owned less than .005 per- cent of their firm’s common stock.23 Primary incentives to focus on the corporation and its shareholders are likely to come from reputational concerns. Academic stud- ies indicate that board members are less likely to be retained and are offered fewer board positions at other firms when their firms experience poor financial perfor- mance.24 The 2001–2002 business scandals and associated media, legal, and regula- tory responses have generated increased concerns among existing and potential board members about reputation and legal liability. On the positive side, these concerns motivate board members to take their responsibilities seriously. On the neg- ative side, they can result in too much caution and impede the corporate decision- making process. They also reduce the supply of qualified individuals who are will- ing to serve on corporate boards. As the editor of Chief Executive magazine observed following the out-of-pocket settlements at WorldCom, some prospective directors are “leaving the playing field . . . they do not want to take the personal risk.”25 The average outside director receives over $115,000 in annual compensation. Typically, part of this compensation comes in the form of equity (or options), which helps to align the interests of the board and shareholders.
Critics argue that the financial and reputational incentives of board members are small relative to the incentives to capitulate to top management. Board members frequently depend on top management to maintain their board seats (even if they are formally nominated by an “independent” committee). Board members can also have incentives to support management to foster business contacts or simply out of
23J. Core, W. Guay, and D. Larcker (1999), “Corporate Governance, Chief Executive Officer Compensation,
and Firm Performance,” Journal of Financial Economics 51, 371–406. 24For example, see S. Gilson (1990), “Bankruptcy, Boards, Banks, and Blockholders,” Journal of Financial
Economics 27, 355–387; S. Kaplan and D. Reishus (1990), “Outside Directorships and Corporate Performance,” Journal of Financial Economics 27, 389–410.
25W. HOLSTEIN, “The Big Chill in the Board Room” (2005), New York Times (May 22).
594 Part 4 Applications of Organizational Architecture
friendship. According to this view, boards are largely “captured” by top management subject to legal and reputational constraints that limit egregious actions that harm the corporation and its shareholders.
CEO turnover provides evidence on the degree of independence of boards. While the probability of a CEO firing is relatively low, there are prominent examples of boards that have fired powerful top executives. A well-publicized example from 2005 is Hewlett-Packard’s firing of Chairman/CEO Carly Fiorina (see the related box for more detail). Research documents that the likelihood of removing a manager with poor stock-price performance increases with the percentage of outside directors on the board.26 There is also evidence that outside directors help to align board and shareholder interests in mergers and the adoption of takeover defenses.27 While this evidence suggests that boards are not completely captured by top management, the degree of independence remains a debated issue. Our view is that public and regula- tory reactions to WorldCom and other corporate scandals have increased the independence of corporate boards.
Top Management
Top Management Authority The chief executive officer (CEO) is the top executive officer of the corporation. While CEOs are arguably the single most important person in most corporations,
M A N A G E R I A L A P P L I C AT I O N S
Hewlett-Packard Fires Its Chairman/CEO On September 4, 2001, Hewlett-Packard (HP) announced that it intended to merge with Compaq Computers through
a $25 billion acquisition. While HP’s CEO Carly Fiorina touted the synergistic potential of the merger, the stock
market greeted the announcement with considerable skepticism—the stock fell about $5 per share (20 percent decline)
at the announcement.
The proposed merger required majority approval in a vote by shareholders. HP’s largest shareholder, the Packard
family’s charitable foundation, announced that it was going to vote against the proposed merger. Major institutional
investors decided to side with Fiorina and support the deal. The proposed merger passed by a very close vote. Walter
Hewlett, son of one of the founders, filed suit to block the merger. In April 2002, the Delaware Court allowed the
merger to proceed.
The controversy placed significant pressure on Fiorina to perform. The benefits of the merger did not materialize as
HP’s stock price languished over the next few years. The HP board fired Fiorina on February 9, 2005. HP’s stock price
increased $1.39 per share to $21.53 on the day of the firing. Some observers argued that the board should never have
supported Fiorina in the first place, and that it bore part of the blame for the company’s problems. Nevertheless, the board
action indicates that it was not completely “captured by the CEO.” Ultimately, Fiorina was held accountable when the
firm failed to perform.
26See M. Weisbach (1988), “Outside Directors and CEO Turnover,” Journal of Financial Economics 20, 431–460.
27See J. Brickley, J. Coles, and R. Terry (1994), “Outside Directors and the Adoption of Poison Pills,” Journal of Financial Economics 35, 371–390; and J. Byrd and K. Hickman (1992), “Do Outside Directors Monitor Managers? Evidence from Tender Offer Bids,” Journal of Financial Economics 32, 195–207. See B. Hermalin and M. Weisbach (2003), “Board of Directors as an Endogenously Determined Institution: A
Survey of the Economic Literature,” Economic Policy Review, Federal Reserve Bank of NY (April), 7–26, for a more detailed discussion of the empirical and theoretical research on boards.
Chapter 18 Corporate Governance 595
they are hired by and report to the board of directors. Ultimately the CEO’s decision authority flows from the board.
The CEO does not have the relevant knowledge or time to make all (or even most) of the decisions within a large and complex organization. One individual cannot be expected to be a fully informed expert in all facets of a complex organization (in- cluding operational strategies, finance, accounting, corporate law, internal controls, marketing, pricing, manufacturing, research and development, and so on). Limits on managerial knowledge and time explain why most large and complex firms decen- tralize decision making to varying degrees. Evidence indicates that top managers delegate more decision rights as the size and complexity of the firm increase.28
The typical CEO’s knowledge, experience, and position are most likely to add value in focusing on broader corporate-level questions, such as: How does the pro- posal fit with the firm’s corporate strategy? How does the proposal relate to other business activities within the firm? Does the proposal affect the firm’s ability to undertake future initiatives? Law professor, Robert W. Hamilton, summarizes this principle:29
In practice, the CEO, as the head of a large bureaucratic organization, cannot hope to run details of the business operations. To be effective, he must delegate authority over day-to-day operations, including personnel, financing, advertising, and production. The CEO should concentrate on the broadest issues relating to the business.
While many decision rights are delegated to lower-level managers, certain deci- sions and activities are performed by the CEO (or other senior executives). For ex- ample, top-level executives generally have responsibilities for shaping the com- pany’s strategic vision and direction, establishing the overall organizational architecture, recruiting and retaining key managers, succession planning, and serv- ing as the primary external spokesperson for the organization.
Large firms often use a “team” of executives to perform the top management func- tions. Many assignments of decision rights at the top of the organization are possible. The optimal design is likely to depend on the company’s environment and strategy, as well as on the specific abilities, specialized knowledge, and talents of the managers. One relatively common design is to divide the top executive duties between a CEO and a chief operating officer (COO).30 In this configuration, the CEO often focuses on external activities, such as investor relations, the media, regulators, and customers, while the COO concentrates on managing internal operations. As described below, often the COO is in line to become the next CEO.
Complex finance, accounting, and legal issues often arise in CEO decision mak- ing. While some CEOs have finance, accounting, or legal training, many do not. It would be rare for a CEO to have technical expertise in all three areas. The typical CEO relies on a group of internal and external experts for advice and consultation on such issues. The typical group of experts includes the chief financial officer (CFO), other finance managers, the controller (chief accounting officer), internal legal staff, an independent accounting firm, tax advisors, external law firms, investment and
28For example, see M. Colombo and M. Delmastro (2004), “Delegation of Authority in Business
Organizations: An Empirical Test,” Journal of Industrial Economics 52, 53–80; and A. Christie, M. Joye, and R. Watts (2003), “Decentralization of the Firm: Theory and Evidence,” Journal of Corporate Finance 9, 3–36.
29R. Hamilton (2000), Law of Corporations (in a Nutshell) (West Group: Saint Paul), 391. 30The second in command may hold other titles, such as “President” or “President/COO.”
596 Part 4 Applications of Organizational Architecture
commercial bankers, and members of the board of directors with the appropriate ex- pertise (particularly members of the audit committee).
The CFO is among the most important positions in the corporation. As described by the Department of Labor:
Chief financial officers direct the organization’s financial goals, objectives, and bud- gets. They oversee the investment of funds and manage associated risks, supervise cash management activities, execute capital-raising strategies to support a firm’s expansion, and deal with mergers and acquisitions.31
The CFO often supervises other senior financial managers such as the controller, treasurer, and risk managers. The role of a CFO in the typical corporation has evolved from a narrow focus on finance and financial reporting to include broader management responsibilities.
WorldCom and other scandals highlight the importance of properly monitoring the CFO. The CFO played a prominent role in many of these scandals, and several CFOs either pleaded guilty or were found guilty of fraud and other charges (e.g., at Enron, WorldCom, and Tyco). Large firms often have internal auditors that monitor the in- ternal controls and transactions within the firm. One of their roles is to limit fraud. The accounting fraud at WorldCom was initially detected by the head of internal audit, Cynthia Cooper. Cooper reported directly to CFO Scott Sullivan, who eventu- ally pleaded guilty to fraud charges. While Sullivan had ordered Cooper to focus on other activities, she persisted in detecting the improper accounting, ultimately bring- ing it to the audit committee’s attention. Investigations initiated by the audit commit- tee revealed that her concerns were valid. The WorldCom example highlights how im- portant it is for internal auditors to have a close relationship with the board’s audit committee. While internal auditors might report to the CFO, they often report directly to the audit committee. The absence of an independent relationship between internal audit and the audit committee at WorldCom increased the personal risk that Cooper faced in pursuing the investigation over her boss’s direct orders.
While corporations can exist indefinitely, the current management will eventually leave the firm. Top management succession is an important process that should be carefully planned by both the CEO and the board. While the board has ultimate responsibility for CEO succession, CEOs often participate in the development and implementation of the succession process and in grooming their replacements.
The COO (or whatever title is second in command) is often the “heir apparent.” Con- ditional on good individual and firm performance, the COO is likely to succeed the cur- rent CEO. Often there is a transition period where the retiring CEO stays on for a year or so as the chairman of the board after the COO assumes the CEO title. The new CEO then becomes the chairman and CEO, while the retired CEO either leaves the board or stays on as an “ordinary” director. This common succession pattern is called passing the baton.32 Some large firms, such as General Electric, employ a horse race where several top executives compete for the top spot until one is chosen as the new CEO. While horse races can generate productive performance incentives among the candidates, such con- tests also reduce the incentives for cooperation. Thus, a horse race is most effective when there are multiple qualified internal candidates for the job, and close cooperation among the candidates is not of critical importance to the organization. (Chapter 14 describes horse races and other tournament-type schemes as incentive processes.)
31Bureau of Labor Statistics, U.S. Department of Labor, Occupational Outlook Handbook, 2004–2005 Edition, Top Executives, www.bls.gov/oco/ocos012.htm.
32See R. Vancil (1987), Passing the Baton (Harvard Business School Press: Boston).
Chapter 18 Corporate Governance 597
Top Management Incentives Performance-based compensation can help align executive and shareholder interests. The analysis in Chapter 15 predicts that firms will pay top managers substantial performance-based compensation, and that managers will receive higher incentive pay in firms where they are more likely to have an important impact on value. The data are generally consistent with these predictions. While the typical CEO of an S&P 500 company received over $6 million in pay in 2004, only about 20 percent of the total pay was straight salary. The remainder consisted of performance-based bonuses, stock options, and other types of performance-based pay. Current U.S. tax laws do not allow corporations to deduct executive compensation in excess of $1 mil- lion unless it is performance-based. Top management also owns a reasonable frac- tion of the typical company’s shares. Research has documented that the mean and median percentages of managerial equity ownership among exchange-listed firms in the United States increased from 12.9 percent and 6.5 percent, respectively, in 1935 to 21.1 percent and 14.4 percent in 1995.33 The largest firms (those with market values in the top 10 percent of sales) had mean and median managerial ownership of 5.4 percent and 1.5 percent in 1995. Researchers have also found that executives tend to receive a higher fraction of their compensation as performance-based pay when they are more likely to have an important effect on the firm (e.g., in high-growth firms).34
Lucian Bebchuk and Jesse Fried argue the typical CEO receives rents (pay in ex- cess of the competitive labor market benchmark) and less incentive-based pay than predicted by standard economic analysis (as summarized in Chapter 15).35 Accord- ing to their managerial power theory, (1) the typical corporate board is captured by managers; (2) some firms have better governance and less managerial capture than others; (3) managers want high pay that is guaranteed (not performance-based); (4) “public outrage” places constraints on the excessive pay that can be taken by the managers; and (5) competition in product, labor, and takeover markets helps to limit executive pay and promote optimal contracts but does not work perfectly. Their analy- sis produces three testable hypotheses. First, the level of CEO compensation is expected to be lower in firms with better governance. Second, top managers are ex- pected to receive more incentive-based compensation in firms with better governance. Third, firms are expected to “camouflage” compensation by paying managers in ways that avoid stark disclosure (e.g., through certain retirement compensation schemes).
The existing empirical evidence is generally consistent with the managerial power hypotheses. For example, CEOs tend to be paid more and have less incentive pay in firms with large boards, less independent boards, and less concentrated ownership. The research, however, is plagued by various statistical problems that are difficult to address with the available data.36 They also are subject to alternative interpretations.
33See C. Holderness, R. Kroszner, and D. Sheehan (1999), “Were the Good Old Days That Good? Changes in
Managerial Stock Ownership since the Great Depression,” Journal of Finance 54, 435–469. 34See J. Gaver and K. Gaver (1993), “Additional Evidence on the Association between the Investment
Opportunity Set and Corporate Financing, Dividend and Compensation Policies,” Journal of Accounting and Economics 16, 125–160; and C. Smith and R. Watts (1992), “The Investment Opportunity Set and Corporate Financing, Dividend, and Compensation Policies,” Journal of Financial Economics 32, 263–292.
35L. Bebchuck and J. Fried (2004), Pay without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press: Cambridge).
36Observed correlations between compensation and various board characteristics can be driven by omitted
variables that drive both compensation and board characteristics. For example, B. Hermalin and M. Weisbach
(1998), “Endogenously Chosen Boards of Directors and Their Monitoring of the CEO,” American Economic Review 88, 96–118, presents a model where CEO talent simultaneously drives executive compensation and board independence. Sorting out cause and effect is difficult given existing data and theory.
598 Part 4 Applications of Organizational Architecture
Some academics, in fact, argue that it can be optimal to pay a CEO “excessively” since it provides strong incentives to lower-level managers who want the job.37
While there are some obvious abuses in executive compensation, it is a debatable issue whether the average CEO is paid excessively or inefficiently. In any case, the agency problems have not been so large as to prevent publicly traded corporations from being the dominant form of organization in the economy.
In contrast to the incentive alignment argument, some critics argue that equity- based compensation (most specifically, stock options) actually increases the agency conflicts between managers and shareholders. These critics point out that the fraud- ulent accounting at companies such as WorldCom was motivated in part by the top managers’ desire to maintain temporarily high stock prices while they exercised their stock options. However, problems caused by poorly designed incentive plans do not imply that all incentive plans are bad and even well-designed incentive systems are subject to a certain amount of “gaming.” The incentives for fraudulent accounting would have been lower at the scandal-plagued companies had top managers not been in the position to exercise their options (i.e., if the options had longer vesting peri- ods). The scandals do suggest that the design of executive compensation plans could be improved in some firms. They do not imply that equity-based compensation is al- ways an inappropriate way to motivate managers.
External Monitors
External parties (sometimes called “watchdogs” or “gatekeepers”) also monitor cor- porate decisions. This section provides a brief discussion of some of the most impor- tant external monitors: public accounting firms, stock market analysts, commercial banks, credit rating agencies, attorneys, and regulatory authorities (Securities Ex- change Commission [SEC] and state attorneys general). Many of these external mon- itors experienced criticism and litigation following the 2001–2002 business scandals.
All publicly traded companies are audited annually by independent accounting firms.38 Independent audits are a “bonding” mechanism that fosters increased in- vestor confidence in the firm’s financial disclosures and thus demand for the firm’s securities. The board and top management also rely on accountants for assessing the validity of internal accounting reports that are used in decision making and control. For example, independent auditors help to assure that divisional managers are not re- porting fraudulent accounting information to top management and the board. Corpo- rate scandals, such as WorldCom, generated concern about whether auditors are suf- ficiently independent from the firms that they audit. Arthur Andersen was essentially destroyed as a company following the Enron scandal. In response to these concerns, major provisions in the Sarbanes-Oxley Act of 2002 are directed at increasing the in- dependence of public accounting firms. For example, the law limits public account- ing firms from providing certain consulting services to their audit clients, and
37See E. Lazear and S. Rosen (1981), “Rank Order Tournaments as Optimal Labor Contracts,” Journal of Political Economy 89, 841–864; and S. Rosen (1982), “Authority, Control, and the Distribution of Earnings,” Bell Journal of Economics 13, 311–323.
38The term independent accounting firms is standard usage. It denotes an accounting firm that is separate from the firm being audited. As we discuss, there is debate as to whether independent auditors are sufficiently
independent from the firms they audit (e.g., due to other business relationships). Another term, that is, used
to describe independent auditors is external auditors.
Chapter 18 Corporate Governance 599
created the Public Company Accounting Oversight Board to monitor the auditing ac- tivities of public accounting firms.
Researchers argue that commercial banks provide important monitoring of corpo- rate decisions.39 Commercial banks are likely to be well informed about a firm from depository and lending relationships. Banks have financial and reputational incen- tives to monitor their loan customers’ business decisions. Depending on the bank’s organizational architecture, however, bank employees can have incentives to take in- appropriate actions to foster business relationships with large corporate customers. Large commercial banks were subject to substantial criticism and litigation follow- ing the 2001–2002 business scandals. Commercial and investment banks from around the world agreed to pay billions of dollars to settle litigation relating to Enron and WorldCom. Investors claimed that the banks had knowingly helped craft and finance transactions that served no other purpose than misleading investors by producing misleading accounting statements.
Investors frequently rely on stock market analysts in making investment decisions. Stock analysts often work for investment banking firms, such as Merrill Lynch, that derive revenue from corporations through such activities as underwriting securities and work on mergers. Investment banking firms allegedly risk losing
M A N A G E R I A L A P P L I C AT I O N S
Commercial Banks and Prepay Transactions Commercial banks were sued and heavily criticized for their participation in billions of dollars worth of prepay
transactions with Enron and other firms. While prepays are legitimate transactions in some settings, they appear to
have been used by some firms simply to produce inappropriately favorable positive accounting statements.
The following is a simplified description of the questionable transactions between major banks (such as Chase and
Citicorp) and Enron. In the typical example, a new company was formed to engage in a transaction with the bank. The
bank agreed to accept the future delivery of some commodity, such as oil, from the new company. The bank, in turn,
“prepaid” for the delivery by providing cash to the new company. The new company would then enter into a contract with
Enron under which (1) Enron agreed to deliver the commodity to the new company in the future, and (2) the company
prepaid for the delivery by giving the cash it had received from the bank to Enron. At this point, the new company had
completely offsetting transactions. It had no cash and offsetting contracts for the receipt and delivery of the commodity.
To complete the cycle, Enron would enter into a forward contract with the bank agreeing to accept future delivery of
the commodity from the bank. In contrast to the other contracts, however, Enron did not prepay the bank for the
delivery. Rather, it promised to pay at the time of delivery. The net result of the transactions was that all three parties
had offsetting positions with respect to the commodity. Enron, however, had the bank’s cash and a promise to pay the
cash back (with implied interest) on the specified delivery date of the commodity.
The net result of the prepay transaction is identical to a loan. Enron obtained cash from the bank at time 0 and
agreed to pay it back with interest at time 1. The complicated prepay transaction, however, was not accounted for as
ordinary debt. Also, the cash was reported as cash flow from operations. These prepay transactions enhanced the
appearance of Enron’s financial statements compared to the standard accounting for bank loans. Accountants who
subsequently reviewed these transactions concluded that the accounting was improper. Lawsuits asserted that the banks
had engaged in the transactions knowing that they were designed to produce misleading accounting statements and had
no legitimate business purpose. Many of the banks and investment banks that helped design and execute these
complicated transactions made large payments to the plaintiffs to settle the lawsuits.
39For example, see D. Diamond (1984), “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies 51, 393–414.
600 Part 4 Applications of Organizational Architecture
significant investment banking fees if their analysts produce reports that are critical of the company, thereby upsetting management. Investigations by the New York At- torney General produced colorful examples where analysts promoted a stock strongly to the public, while privately acknowledging that the company was in seri- ous trouble. Major investment banks agreed to large payments and structural changes to settle and prevent potential litigation. Several Merrill Lynch executives were sen- tenced to jail for helping Enron enhance its financial statements through the im- proper sale of floating power plants in Nigeria. While management pressures have motivated some analysts to be overly optimistic, research indicates that reputational concerns help to limit analyst optimism.40 The Sarbanes-Oxley Act of 2002 contains provisions that are directed at reducing the pressure that investment banks place on research analysts to produce positive reports.
S&P, Moody, and Fitch rate the corporate debt of large companies for default risk. Special regulatory status allows these rating agencies to obtain information from companies that are not provided to other outsiders. Rating agencies were criticized for not being more active in detecting or preventing the 2001–2002 corporate scan- dals. Critics stressed the potential conflict of interest that arises from the fact that companies pay the rating agencies to rate their debt issues. This conflict, however, is arguably small since corporate debt issuers have little choice in using the major rat- ing agencies. Also, no one corporate client is responsible for a large share of the rat- ing companies’ revenues.
Firms frequently obtain advice from outside law firms on corporate disclosures and transactions. Some law firms obtain a substantial portion of their revenues from large corporate clients. Law firms were criticized in the 2001–2002 corporate scandals for not bringing specific concerns about management, transactions, and disclosures to the attention of the board. The Sarbanes-Oxley Act of 2002 contains provisions pertaining to attorneys. For example, it requires the SEC to set minimum standards for professional conduct for attorneys practicing before it.
Elihu Root’s Timeless Advice on Attorney Conduct Scholars widely regard Elihu Root (1845–1937) as among the most important and distinguished public servants in
American history. Root was a prominent attorney who served as both Secretary of State and Secretary of War under
President Theodore Roosevelt. He also was a U.S. senator from New York and won the Nobel Peace Prize in 1912 for
his many efforts on behalf of increasing international understanding.
Theodore Roosevelt who served as America’s 26th president (1901–1909) was a very strong-willed and intimidating
person. Root was among the few people that Roosevelt could always count on for a candid opinion. In Root’s words,
“about half the practice of a decent lawyer is telling his clients that they are damned fools and should stop.”
The SEC named attorneys as respondents or defendants in more than 30 enforcement actions in 2003 and 2004. A
common charge was that the attorney had failed to give candid legal advice to the board or the audit committee about
an illegal accounting transaction. In reflecting on these charges, the SEC’s director of enforcement stated:
Many of those we charged could have avoided problems if they had heeded Elihu Root’s advice. We have many examples of lawyers who twisted themselves into pretzels to accommodate the wishes of company management, and failed in their responsibility to insist that the company comply with the law.
Source: S. M. Cutler, Director of the Division of Enforcement of the SEC (2004), “The Themes of Sarbanes-Oxley as Reflected in the
Commission’s Enforcement Program,” speech, UCLA School of Law, September 20.
H I S T O R I C A L A P P L I C AT I O N S
40A. Leone and J. Wu (2007), “What Does It Take to Become a Superstar? Evidence from Institutional
Rankings of Financial Analysts,” working paper, University of Rochester, Rochester, NY.
Chapter 18 Corporate Governance 601
A cornerstone for monitoring by outsiders, including shareholders, is the timely and accurate disclosure of corporate financial information. The Securities Acts of 1933 and 1934 were primarily targeted at improving corporate disclosures. One of the SECs principle functions is to help assure that investors receive material infor- mation for making investment decisions. The SEC also investigates companies for possible violations of securities laws. As a governmental agency with limited staff, the SEC is not intended to have primary responsibility for assuring proper financial statements among the roughly 13,000 publicly traded corporations. For example, the SEC, which has been in existence since 1934, did not initially detect the 2001–2002 scandals, including those at Enron, WorldCom, and Tyco. Ultimate responsibility falls on corporate managers who are monitored by independent auditors and other private-sector entities. State attorneys general also monitor corporations (incorpora- tion occurs under state law). The New York Attorney General has been particularly active in investigating companies following the 2001–2002 business scandals.
International Corporate Governance Germany and Japan frequently are cited for corporate governance that differs from that in the United States. In contrast to the United States, German and Japanese cor- porations are not directed primarily at maximizing shareholder wealth. Rather, their traditional focus has been on a broader set of stakeholders including employees, banks, affiliated companies, the broader community, and shareholders. Both of these countries historically have had weaker shareholder protection laws than in the United States.
Japanese corporations generally have somewhat larger boards than found in U.S. companies. Historically these boards have been comprised of managers, former em- ployees, managers of affiliated companies, and bank managers. Few, if any, of these boards have had independent directors. Banks have taken an active role in gover- nance—especially when firms are in financial distress. Another common characteris- tic of traditional Japanese firms is extensive reciprocal holdings of common stock among affiliated corporations. Because of regulation and the distribution of stock ownership, hostile takeovers have been rare in Japan.
German companies have a two-tier board system. The supervisory board consists of large shareholders (including banks, corporations, and insurance companies) and em- ployee representatives. Employee representatives have 50 percent of the board seats. The supervisory board selects a management board that has primary operational au- thority. Similar to Japan, reciprocal holdings of the voting stock of affiliated companies are common; banks have taken an active role in governance; hostile takeovers are rare.
Top-level executives receive incentive-based compensation throughout the world. According to Towers Perrin’s 2003–2004 survey of worldwide compensation, the typical U.S. CEO received 63 percent of compensation in the form of variable pay.41
The average German and Japanese CEO received 51 percent and 19 percent, respectively. U.S. CEOs had the highest percentage of variable-based pay among the 26 countries that were surveyed; the second highest was Singapore (59 percent). CEOs in New Zealand and China (Shanghai) had the smallest percentages (15 percent and 18 percent, respectively). According to Towers Perrin, the dominant form of equity-based compensation is stock options. Of the countries surveyed, France
41www.towersperrin.com/hrservices/webcache/towers/United_States/publications/Reports/2003_04_
Worldwide_Remuneration/WWTR_2003_English.pdf
602 Part 4 Applications of Organizational Architecture
led with 90 percent of companies reporting the use of stock options, followed by Belgium, Canada, and the United States (85 percent). Companies in China, represented by Hong Kong and Shanghai, reported usage levels of 55 percent and 35 percent, respectively. While China trailed most large industrial nations, it ranked ahead of re- gional competitor India, at 20 percent. Towers Perrin reports that there has been a relative increase in the use of restricted stock awards in the United States and several other countries due to changes in accounting rules relating to the expensing of options and public concerns about option plans. The average CEO in the United States receives significantly higher total compensation than in other countries.
The most common incentive conflict in the United States is between outsider shareholders and the board/managers who own limited amounts of stock in the firm. Conflicts between controlling inside shareholders and outside shareholders are frequently observed in other countries where the stock is less widely held. The Italian company Parmalat provides an important example of this type of conflict. Parmalat was founded by Calisto Tanzi in the early 1960s. By 2002 it had become a publicly traded corporation with reported global sales of over 7.5 billion euros. Nevertheless, the Tanzi family maintained voting control of Parmalat’s stock, and five Tanzi family members served on the company’s seven-member board. In De- cember 2003, Parmalat revealed that it had overstated assets by billions of dollars through fictitious accounts. Tanzi admitted to “siphoning off 500 million euros” from the company. Expropriations of corporate assets by other Tanzi family mem- bers were documented. The SEC called Parmalat “one of the largest and most brazen corporate financial frauds in history;” and it was dubbed by the media the “European Enron.”42 Outside shareholders who had little control over the firm’s activities essentially lost their entire investments when the fraud was revealed.
The relatively strong performance of U.S. companies during the 1990s motivated many foreign countries and companies to adopt “investor reforms” based on the U.S. model. Japanese regulations were changed to allow executive stock options, and Japanese companies have begun adding outside directors to company boards. Other examples include Brazil, India, Kyrgyz Republic, Malaysia, South Africa, Thailand, and various western European countries. Many of these proshareholder governance changes were motivated by hopes of enticing foreign investors who are reluctant to invest in countries and/or companies with weak shareholder protections. A recent survey of institutional investors by McKinsey and Company indicates that institu- tional investors consider governance issues as important as financial analysis in de- ciding on whether or not to invest in a given company. Movement toward the U.S. model has not stopped due to the governance scandals of 2001 and 2002.
The increased emphasis on shareholder wealth in other countries is evidenced in the turnover of CEOs. Historically U.S. CEOs faced a higher risk of performance-based turnover than CEOs in most other countries. This was not the case in 2004. CEO turnover reached historic highs in 2004 in Europe and various Asian/Pacific coun- tries.43 Much of this turnover was performance related. For example, CEO turnover increased to 17.5 percent per year in Europe from 11 percent in 2003; turnover was even smaller in earlier years. Close to 45 percent of the 2004 turnovers in Europe were classified as performance-related.
42Parmalat has also been compared to the U.S. scandal at Adelphia where members of the founding family
were accused (and in some cases convicted) of various charges relating to fraud and theft from the firm. 43Data are from an annual survey of CEO turnover conducted by Booz Allen Hamilton. See www. boozallen.de/
content/downloads/ceo_succession_2004.pdf
Chapter 18 Corporate Governance 603
M A N A G E R I A L A P P L I C AT I O N S
Hermes’ Focus on Corporate Governance in Japan Hermes Pension Management Limited is a large British institutional investor. In 2000 it announced it had appointed a
resident Japanese corporate governance advisor to assist with the development of its international governance
programs.
The new position was staffed by Mr. Ariyosh Okumura, formerly chief executive of IBJ Asset Management. His
first tasks were to supervise a Japanese translation of Hermes’ International Governance Practices and to explain these
governance principles to the 450 Japanese public companies in which Hermes has shareholdings. Hermes also planned
to hold private meetings with as many companies as possible to discuss their governance practices.
Hermes has been among the most active of European institutional investors in the corporate governance process. It
has formed joint agreements with major U.S. pension funds to collaborate on governance issues both in the United
States and internationally.
This example illustrates the active role that some institutional investors (especially public pension funds) play in the
corporate governance process.
Source: Hermes (2000), company press release (March 28).
U.S. corporate governance is sometimes criticized for being overly focused on shareholders. After all, aren’t employees and other corporate stakeholders impor- tant? These critics fail to recognize that shareholder value is not maximized by mistreating employees, cheating customers, or destroying local communities. If a company is successful in making profits over the long run many stakeholders bene- fit. The company survives; workers are employed; communities receive tax revenues; customers obtain products that they value. Companies that continually fail to make profits eventually go out of business, and many stakeholders suffer. By focusing on shareholder value (the residual cash flows) managers have incentives to search for new revenue-producing opportunities and for less costly production meth- ods. Ultimately this activity leads to more efficient use of the limited resources in the economy and higher standards of living.
When companies are growing and profitable, shareholder and employee interests largely coincide. Focusing on the interests of multiple stakeholders causes few problems under these conditions. A prominent case where stakeholder interests di- verge is when firms need to downsize or move employment “offshore” to remain competitive. Under these conditions, if a firm fails to reduce domestic employment shareholders suffer, and ultimately the firm will go out of business. Nevertheless, employees who expect to lose their jobs would be better off if the firm did not downsize (even if it causes the firm to suffer financially and eventually to go out of business). The U.S. governance model provides managers with clear guidance in this situation—reduce domestic employment since it increases shareholder value. Governance models that focus on multiple stakeholders do not provide clear guid- ance on how managers should weigh the interests of the competing stakeholders. While competitive pressures may ultimately force companies with stakeholder ob- jectives to make employment adjustments, the adjustments are likely to be delayed and more expensive than under the U.S. model. Global competition placed extreme pressure on German manufacturing companies during the 1990s to reduce employ- ment at domestic plants and to increase employment at foreign subsidiaries that paid substantially lower wages. German companies adjusted, but only after significant public controversy and costly negotiations with trade unions. As an example,
604 Part 4 Applications of Organizational Architecture
Siemens increased employment outside Germany by 40 percent to 162,000 between 1985 and 1995, while reducing German employment by 12 percent (156,000 to 141,000).44 Making these changes required Siemens to deal with resistance from employee representatives on the board, trade unions, and the media. Japanese com- panies faced similar problems in adjusting to economic shocks in the 1990s.
Market Forces Corporate boards and managers face important constraints imposed by external con- trol mechanisms. In this section, we briefly discuss three important external control mechanisms: the market for corporate control, the managerial labor market, and product market competition.
Market for Corporate Control One of the most important external control mechanisms is the market for corporate control. If a management team fails to maximize the value of the firm, it can prompt
44D. Audretsch and M. Fritsch (2003), “Linking of Entrepreneurship to Growth: The Case of West Germany,”
Industry and Innovation 10(1), 65–73.
M A N A G E R I A L A P P L I C AT I O N S
Sony Corporation ( Japan) Increases Outside Directors The Japanese economy entered a period of sustained decline in the 1990s, following its meteoric rise in the 1980s.
During the 1990s, the Japanese stock market declined by 50 percent, while the U.S. stock market soared. Many
features of the traditional Japanese corporation could not be maintained in this new environment. For example, many
Japanese companies had to renege on implicit lifetime employment contracts. They also were motivated to make
changes in their governance systems to promote foreign investment.
Sony Corporation issued a press release in January 2003 announcing “reforms” in its management structure that
were being made “to strengthen the distinction between oversight and business operation roles.” The following changes
were among those listed in their press release:
Composition of Board of Directors: The Board of Directors will have between 10 and 20 directors. Regulations governing the qualifications for director-candidates will be established in order to eliminate conflicts of interest and ensure independence. The intention is to increase the number of outside directors from the present level of three.
Chairman of the Board: Separation between Chairman of the Board and Representative Corporate Executive Officer will be regulated.
Composition of Committees:
Nomination Committee: The Nomination Committee will be composed of five or more directors and the majority will be outside directors. However there will be at least two internal directors.
Compensation Committee: The Compensation Committee will be composed of three or more directors and the majority will be outside directors. However there will be at least one internal director. The CEO and COO will not be chosen for this Committee.
Audit Committee: The Audit Committee will be composed of three or more directors and the majority will be outside directors. There will be at least one full-time member. All members of the Audit Committee will not have business operation responsibilities and will satisfy the independence requirements of U.S. corporate reform legislation. In principle, Audit Committee members will not become Nomination Committee or Compensation Committee members.
Source: Sony Group (2003), company press release, “Reforming the Sony Group Management Structure to Strengthen Corporate
Governance,” (January 28).
Chapter 18 Corporate Governance 605
a hostile takeover offer from a competing management team who thinks they can do a better job. The United States, with a relatively protakeover regulatory environment, has had a particularly active takeover market. For example, between 1993 and 1999 the value of corporate mergers represented 8.4 percent of the gross domestic product (GDP).45 The market for corporate control, while important in many countries, is less active where there are greater legal restrictions on takeovers.
In order for market forces to perform their control functions, a certain level of in- formation must be provided to these markets. For example, the market for corporate control must be able to identify firms that are not maximizing shareholder value. Again, we see the often overlooked, but vitally important, roles of financial disclo- sure in corporate governance.
Managerial Labor Market Another important external control mechanism is the managerial labor market.46
Reputation is important in determining the professional opportunities that an indi- vidual receives. Managers who perform poorly at one company are less likely to be offered management positions or board seats at other companies.
Product Market Inefficient firms have higher costs than more efficient firms and eventually fail in a competitive marketplace. Thus, the product market is another external mechanism that limits managerial agency problems.47 Global Crossing, WorldCom, and other
Postretirement Incentives of CEOs Career concerns potentially mitigate agency problems between managers and shareholders. Such concerns arise from
both the external labor market, which provides managers with outside opportunities, and the internal labor market,
which determines how quickly and on what terms a manager is promoted through the hierarchy in his or her own
organization. Managers realize that if they perform poorly, these labor markets will downgrade the assessments of their
abilities and demand for the managers will decline.
It regularly has been argued that career concerns became negligible during the last years of active employment.
Evidence suggests, however, that CEOs face career concerns even in this later period of employment. Retired CEOs
frequently hold multiple board seats that give them both pecuniary and nonpecuniary benefits. Both the likelihood of
CEOs serving on their own boards two years after departure as well as the likelihood of serving as outside directors on
other boards are positively and strongly related to the financial performance of their firms in their final years of active
employment. Assuming the typical CEO values these positions, the effect of performance on postretirement
opportunities provides incentives to CEOs in their final years of active employment.
Source: J. Brickley, J. Linck, and J. Coles (1999), “What Happens to CEOs After They Retire? New Evidence on Career Concerns,
Horizon Problems, and CEO Incentives,” Journal of Financial Economics 52, 344–377.
A C A D E M I C A P P L I C AT I O N S
45See J. Weston, J. Siu, and B. Johnson (2001), Takeovers, Restructuring and Corporate Governance, 3rd edition (Prentice Hall: Upper Saddle River).
46See E. Fama (1980), “Agency Problems and the Theory of the Firm,” Journal of Political Economy 88, 288–307.
47See A. Alchian (1950), “Uncertainty, Evolution and Economic Theory,” Journal of Political Economy 58, 211–221; and O. Hart (1983), “The Market Mechanism as an Incentive Scheme,” Bell Journal of Economics 14, 366–382.
606 Part 4 Applications of Organizational Architecture
companies involved in recent scandals ultimately filed bankruptcy petitions when their revenues were unable to cover their costs. Managers have both financial and reputational incentives to avoid bankruptcy.
Sarbanes-Oxley Act of 2002 Congress was under substantial pressure to take action after the business scandals that emerged in late 2001 through the middle of 2002. It responded in July 2002 by passing the Sarbanes-Oxley Act of 2002 (SOX). SOX has a wide range of provisions and touches on many of the issues that arose during the business scandals, including internal monitoring, public auditing, activities of external monitors, executive loans, and disclosure.48
SOX establishes the Public Companies Accounting Oversight Board (PCAOB) to oversee public accountants’ audits of publicly traded corporations. The PCAOB is appointed by the Securities and Exchange Commission (“after consultation with” the Chairman of the Federal Reserve Board and the Secretary of the Treasury). The Act contains various rules and regulations that affect public accounting firms, the boards and management of public companies, and other monitors such as research an- alysts. The Act prohibits various transactions between companies and their manage- ment (such as personal loans to executives). It requires CEOs and CFOs to certify the accuracy of their financial statements, and establishes civil and criminal penalties for violations of the Act.
M A N A G E R I A L A P P L I C AT I O N S
WorldCom—An Important Lesson in Ethics for All Employees The Sarbanes-Oxley Act of 2002 focuses much of its attention on top-level executives. The example of Betty Vinson at
WorldCom, however, emphasizes that lower-level employees also have legal and ethical responsibilities.
Betty Vinson was a midlevel manager who made fraudulent entries in the accounting system at WorldCom. She
pleaded guilty to fraud in 2002 and cooperated with the government in its case against Bernard Ebbers. Following
Ebber’s conviction, she was sentenced to five months in prison on August 5, 2005.
Vinson testified that she was pressured by the CFO to make the false accounting entries. The CFO had told her that
Ebbers did not want to lower Wall Street expectations. She was assured by the CFO that “all was well.” She stated, “I
felt like if I didn’t make the entries, I wouldn’t be working there.” Asked how she chose which accounts to alter, Vinson
testified, “I just really pulled some out of the air. I used some spreadsheets.”
While Vinson acknowledged her guilt, she had hoped to avoid prison time because she had cooperated with the
government. U.S. District Judge Barbara Jones was sympathetic, but nevertheless held Vinson responsible. Jones
concluded, “Ms. Vinson was among the least culpable members of the conspiracy at WorldCom. Still, had Ms. Vinson
refused to do what she was asked, it’s possible this conspiracy might have been nipped in the bud.”
Corporate fraud often requires the assistance of multiple individuals. Lower-level employees may feel pressured to
comply with a superior’s request to engage in an illegal action. The lesson from WorldCom and other recent scandals is
that employees should not expect to escape criminal or civil liability simply because they “were following orders.”
Employees are legally and ethically responsible for their own actions, whether or not they are ordered to do something
by their boss.
Source: M. Graybow (2005), “Former WorldCom Accountant Sentenced,” Reuters (August 5).
48See www.aicpa.org/info/sarbanes_oxley_summary.htm for a detailed summary of the law.
Chapter 18 Corporate Governance 607
Section 404 has proven to be the most controversial and costly provision in SOX. Section 404 requires companies to report annually on the internal controls over their financial statements. Independent auditors are to attest to and report on manage- ments’ assessment of the firm’s internal controls over the financial reports. Comply- ing with this provision has turned out to be a massive undertaking. Industry estimates put the national cost of just complying with Section 404 of SOX at $35 billion.49
The relative costs and benefits of alternative organizational forms can change due to changes in the business environment and/or strategy of the firm. SOX represents a significant change in the business environment. The new demands on corporate boards and the limitations on management contracts and corporate actions increase the costs of organizing as a public corporation substantially. While many large firms have no feasible alternative to organizing as publicly traded corporations, some smaller firms have chosen to “go private” and convert to closely held companies. Other firms have delayed going public. Moreover, it is likely that the availability of financing for start-up firms will decline since venture capitalists will require a higher threshold of success to help assure that they can liquidate their investment by taking the start-up public. Some foreign companies have decided to quit being listed on U.S. exchanges. SOX might also encourage mergers if there are scale economies in
M A N A G E R I A L A P P L I C AT I O N S
The Economic Costs of Sarbanes-Oxley (SOX) To gauge the total economic costs associated with SOX, one study examines broad movements in the stock market
surrounding key events leading to the passage of Sarbanes-Oxley. On the assumption that the market incorporates into
stock prices in a timely and unbiased fashion the release of new information about future discounted cash flows, the
study indicates the cumulative abnormal return of the market index stemming from the legislative events leading to the
passage of SOX is about $1.4 trillion. This amount represents the decline in the market value of publicly traded
equities in the United States on those days that SOX moved through the legislative process.
The largest SOX-related stock market decline occurred when President Bush, in a speech on July 9, 2002, signaled
a change of attitude in Washington stating the federal government had to get tough on corporate crime. The passage of
SOX-type laws that were considered inconceivable before the speech became imminent after President Bush expressed
his agreement with Senate Democrats on the goals of reforms. The market realized a significant negative abnormal
return (�2.28 percent) on the day of his speech. Furthermore, firms with more complex business lines and more
extensive foreign operations experienced a larger decline in their market returns on account of SOX, a further
indication of the economic effect on business. In addition, the cumulative abnormal market returns associated with the
announcement that some firms would obtain an extension on when they had to comply with SOX experienced higher
positive abnormal market returns than firms that were subject to early compliance.
The study also examined other news events occurring during the SOX deliberations that potentially might confound
significantly abnormal negative stock returns attributable to SOX. Although there were other government rulemaking
activities, accounting scandals, and economic reports that became public during the SOX deliberations, an examination
of the exact timing of these news releases indicates that they are unlikely to account for the huge negative market
return over the key SOX-related legislative events.
The study’s author offers a caveat on the $11.4 trillion estimate of the economic costs of SOX. This figure
incorporates not just the economic costs of SOX, but any additional concerns the market has that SOX also might
signal a change in the behavior of lawmakers toward tighter anti-business government controls.
Source: I. Zhang (2007), “Economic Consequences of the Sarbanes-Oxley Act of 2002,” Journal of Accounting and Economics 44, 74–115.
49See T. Bisoux (2005), “The Sarbanes-Oxley Effect,” BizEd (July/August), 24–29.
608 Part 4 Applications of Organizational Architecture
complying with the Act. While the overall merits of the Act can be debated, one potentially unanticipated consequence is its effect on organizational choice.
Various researchers have tried to estimate the realized costs and benefits of SOX. While the evidence is controversial, it generally supports the notion that the costs have been significant, while the benefits have been elusive.50 Concerns about com- pliance costs have motivated the SEC to take various actions, such as delaying Sec- tion 404 application for small and foreign firms.
Corporate Governance: An Historical Perspective The 2001–2002 spate of scandals produced worldwide concern about corporate gov- ernance and whether it was fatally flawed in most, if not all, publicly traded corpo- rations. These concerns contributed to the 23 percent decline in the S&P 500 stock market index that occurred in 2002. Nevertheless, the dominance of publicly traded corporations has continued, and the stock market has rebounded. The S&P 500 in- creased nearly 40 percent between the end of 2002 and August 2005 despite a surge in oil prices and worldwide concerns about war and terrorism.
The ongoing strength of the stock market is not surprising when viewed in an his- torical perspective. Throughout history, as business environments have changed (mar- kets, regulation, and technology) new control problems have developed that have re- sulted in business scandals. This process has not resulted in the demise of the public corporation. Rather, corporate governance has evolved, and business has progressed.
Consider the profound changes that occurred in the economy in the early 1900s. After World War I, the U.S. economy grew rapidly under President Coolidge’s probusi- ness policies. From 1923 to 1929 the quantity of manufactured goods almost doubled. Automobile sales grew from 1.5 million in 1921 to 4.5 million in 1929. The stock market soared. During this time period the publicly traded corporation asserted itself as the dominant form of organization in the industrial sector. On “Black Tuesday” (October 19, 1929), the stock market crashed and the Great Depression followed. During the 1920s, the Dow Jones Industrial Average (major stock market index) nearly quadrupled reaching a historic high of 381.17 on September 3, 1929; by June 1932 it had fallen to 41.22 (losing almost 90 percent of its value).
Subsequent investigations alleged accounting “scams,” illegal trading, conflicts of interests, and other major problems with corporate governance. These allegations, how- ever, resulted in private sector and governmental changes in corporate governance—not the demise of the publicly traded corporation. No governance system works perfectly, and other business scandals occurred over time. In 1938, McKesson and Robbins exec- utives embezzled more than $18 million and hid the theft by creating a fake division rep- resenting one-fifth of the company’s assets. The auditor, Price Waterhouse, missed the fraud. Large scandals arose in the 1960s and 1970s at Mates Fund and Equity Funding. Despite the occurrence of these and other scandals, public corporations continued to survive, and governance systems have continued to evolve. The Dow Jones on December 1, 2005, was around 10,900 compared to its 1920s high of 381.
The second half of the twentieth century witnessed profound economic change with the development of the “information age” and the globalization of markets. Public corporations were confronted with new control problems, which put stress on existing control systems. As Federal Reserve Chairman Alan Greenspan remarked in July 2002,
50See L. Ribstein (2005), “Sarbanes-Oxley After Three Years,” Illinois Law and Economics, working paper,
#LE05-016 for a review and discussion of this research.
Chapter 18 Corporate Governance 609
“the avenues to express greed have grown enormously.” CFO Andrew Fastow used complex derivatives to commit fraud at Enron; a financial “tool” that did not even exist 20 years earlier. Fraud had been easier to detect and monitor in the “simple world” of stocks and bonds.
Increased complexity in the world implies that managers should carefully evalu- ate the control issues when contemplating expansions into new activities and mar- kets. Strategic decisions that might look good from a pure business standpoint can prove unwise when one considers the governance costs. Consider Royal Ahold’s cor- porate strategy in 2000 and 2001 to expand its grocery store business around the world through multiple acquisitions. The company, which is headquartered in the Netherlands, acquired at least 13 new companies in the United States, Scandinavia, Spain, Argentina, and the Netherlands during this two-year period alone. The rapid expansion produced control problems that the company was not prepared to con- front, and an accounting scandal surfaced in 2003. Foreign subsidiaries had pro- duced massively fraudulent accounting statements, apparently orchestrated by divi- sional managers who wanted to earn higher accounting-based bonuses. Following the scandal, Royal Ahold retreated from its rapid merger strategy, sold off various “noncore” assets, and strengthened internal controls at both the corporate and divi- sional levels.
The debate on how to improve corporate governance continues in the aftermath of the recent corporate scandals. This debate is useful since it could lead to new insights into how to improve corporate governance. It is important to recognize, however, that corporate governance is not as flawed as some critics contend. In contrast to popular characterizations, top executives are not given absolute authority to run
M A N A G E R I A L A P P L I C AT I O N S
Tyco International—Corporate Governance Failure or Success? Tyco International Ltd. is a diversified manufacturing and services company that was embroiled in a large corporate
governance scandal. Problems initially surfaced in December 1999 when Tyco disclosed that the SEC was conducting
an informal inquiry of the company. In June 2000, Tyco announced it was amending its reported earnings for 1999 and
the first quarter of 2000. During the first five months of 2002, Tyco’s stock price fell from $56 to less than $10 per
share. CEO Dennis Kozlowski abruptly resigned on June 3, 2002. On September 13, 2002, Kozlowski and the former
CFO were indicted for theft, fraud, and violation of securities laws. The indictment charged that they had used Tyco as
a “personal piggy bank” to purchase millions of dollars worth of residences, yachts, artwork, personal investments, and
even $17,000 umbrella stands. The indictment charged that the total illegal enrichment was around $600 million. The
former CEO and CFO were subsequently found guilty in court.
Tyco hired Ed Been from Motorola as its new CEO in July 2002. Been’s top priority was to improve Tyco’s
corporate governance and to restore confidence in the company. He encouraged more internal policing by installing an
ombudsman at Tyco and giving workers an ethics guide called “Doing the Right Thing.” He replaced all of Tyco’s top
executives, two of its five division presidents, and asked the former board to resign. He moved Tyco’s operating
headquarters from New York City to a more modest office park in West Windsor, N.J. In the three years since Been was
hired, Tyco’s stock price tripled, substantially outperforming the S&P 500.
Tyco has been cited as a major corporate governance failure—yet one more example of fatally flawed governance
in U.S. corporations. From a longer-term perspective, Tyco could be characterized as a governance success. While the
company and its shareholders suffered when the scandal surfaced, the guilty parties were ultimately sent to jail and the
governance problems corrected. Three years later the company was “back on track” and performing well. Consistent
with the principle of Economic Darwinism, Tyco had to respond to external pressures and change its organizational
architecture to survive.
610 Part 4 Applications of Organizational Architecture
corporations as personal fiefdoms. Consistent with the organizational architecture framework, the U.S. governance model attempts to separate decision management from decision control and to provide incentives to corporate decision makers to take productive actions. From time to time, business scandals emerge. However, this will occur under any feasible governance system, especially in times of rapid change. De- signing governance systems that eliminate all agency conflicts is usually too costly. It is probably efficient for some scandals to occur. As SOX illustrates, new regulation entails both costs and benefits, as do privately initiated changes in governance at the firm level. While improvements in governance are conceptually possible, it is criti- cal to consider both the costs and benefits when evaluating governance changes at ei- ther the firm or regulatory level.
Summary Corporations have the legal standing of an individual (distinct from its shareholders) and can enter into contracts and participate in lawsuits. Shareholders have limited li- ability (only their initial capital contribution is subject to risk). Some corporations are closely held, while others are publicly traded. Publicly traded companies are often listed on organized stock exchanges. The largest exchange in the world is the New York Stock Exchange (NYSE), which provides an extremely active and liquid market for trading shares.
Institutional investors (e.g., mutual and pension funds) now own about 50 percent of the stock of publicly traded corporations. While the typical large firm has thou- sands of “small” shareholders, many have blockholders that own a nontrivial fraction of the shares. The relatively high frequency of widely held corporations in the United States is partially explained by the country’s well-developed stock markets and legal system that help to protect the interests of small shareholders.
Corporate governance is the popular term used to describe organizational architecture at the top of a corporation. Alternative governance systems are often evaluated based on three key objectives that relate to value creation and survival of corporations: (1) the motivation of value-maximizing decisions; (2) the protection of assets from unauthorized acquisition, use, or disposition; and (3) the production of proper financial statements that meet the legal requirements.
Operational control of large corporations is delegated to professional managers who are overseen by a board of directors who have limited financial interests in the firm. Concerns about separation of ownership and control have led some scholars to question the social and productive efficiency of the corporate form of organization. Nevertheless, large publicly traded corporations have accounted for most of the free world’s industrial output for decades. Raising capital from diversified investors is particularly important for large firms that require significant funds to finance invest- ment, and is the primary reason why most large firms are organized as publicly traded corporations. Public corporations also benefit from not having to restrict the supply of top managers to people who are rich enough to buy large firms.
Separation of decision control and decision management is critical when, as in the case of publicly traded companies, decision makers do not bear the full wealth effect of their actions. Top-level authority in corporations is divided among shareholders, the board of directors, and top management. Other groups that can have roles in the decision-making process include the bondholders, preferred stock stockholders, lenders, independent auditors, and stock/credit analysts. The allocation of decision rights at the top of the firm is determined by law/regulation and voluntary choices, such as signing an agreement that grants specific decision rights to the contracting parties.
Chapter 18 Corporate Governance 611
While shareholders are traditionally viewed as the ultimate owners of the corpo- ration they have only limited powers to participate in the management of the company. Controversy exists as to whether shareholders should be given additional decision rights in the United States. Shareholders can be divided into three basic types: Small shareholders, institutional investors, and large blockholders. All share- holders benefit from increases in share price. However, they vary in their incentives to participate in the governance process and in terms of countervailing incentives that can motivate actions that are inconsistent with maximizing the value of the shares.
While the board of directors has primary legal authority for managing the firm, the typical board delegates much of this authority to professional managers. The board’s primary function is top-level decision control—general oversight of the cor- poration and ratification of important decisions. Board composition, structure, and processes vary significantly across firms and through time—there is no one design that is optimal for all firms. Debate exists over whether the typical board is “captured by managers.” Prominent examples exist where boards have fired powerful chair- men/CEOs.
The chief executive officer (CEO) is the top executive officer of the corporation. The CEO does not have the relevant knowledge or time to make all (or even most) of the decisions within a large and complex organization. Many decisions are delegated to lower-level employees. Succession planning is an important task performed by the board and top management.
Top managers from throughout the world receive a reasonable fraction of their pay in the form of performance-based compensation. Nevertheless, debate continues on whether the typical firm uses optimal incentive plans and whether the typical CEO receives more than a competitive wage.
Prominent external monitors include public accounting firms, stock market ana- lysts, commercial banks, credit rating agencies, attorneys, and regulatory authorities [Securities Exchange Commission (SEC) and state attorneys general]. Many of these external monitors experienced criticism, litigation, and increased regulation follow- ing the recent business scandals.
German and Japanese governance systems are not directed at maximizing share- holder wealth. Rather their traditional focus has been on a broader set of stakeholders including employees, banks, affiliated companies, the broader com- munity, and shareholders. The relatively strong performance of U.S. companies during the 1990s motivated many foreign countries and companies to adopt “in- vestor reforms” based on the U.S. model. One problem with governance systems that focus on multiple stakeholders is that they do not provide clear guidance to managers when the interests of stakeholders conflict.
Corporate boards and managers face important constraints imposed by external control mechanisms. Three of the most important external control mechanisms are the market for corporate control, the managerial labor market, and product market competition. Corporate disclosures of financial information allow these external mechanisms to help control corporate insiders.
Congress responded to a flurry of business scandals by passing the Sarbanes-Oxley Act of 2002 (SOX). SOX has a wide range of provisions and touches on many of the is- sues that arose during the business scandals, including internal monitoring, public auditing, activities by external monitors, executive loans, and disclosure. The new de- mands on corporate boards and the limitations on management contracts and corporate actions increase the costs of organizing as a public corporation substantially. While
612 Part 4 Applications of Organizational Architecture
many large firms have no feasible alternative to organizing as publicly traded corpora- tions, some smaller firms have chosen to “go private” and convert to closely held com- panies. Others have delayed going public. While the evidence is controversial, it generally supports the notion that the costs of SOX have been significant, while the benefits have been elusive.
The debate on how to improve corporate governance continues in the aftermath of the 2001–2002 corporate scandals. This debate is useful since it could lead to new insights into how to improve corporate governance. Nevertheless, it is impor- tant to recognize that corporate governance is not as flawed as some critics con- tend. While improvements in governance are conceptually possible, it is critical to consider both the costs and benefits when evaluating governance changes at either the firm or regulatory level.
D. Chew Jr. and S. Gillan, Eds. (2005), Corporate Governance at the Crossroads, A Book of Readings (McGraw-Hill Education: New York).
18–1. Your boss notes that “small shareholders typically free ride on the voting process, while tra- ditionally most institutional investors have not been active in the governance process. Thus,
management often appears to control the proxy solicitation process. Moreover, their propos-
als almost always pass.” Based on these observations she has concluded that shareholder
voting is a “useless process.” She asks your opinion.
18–2. Cisco shareholders recently voted down a shareholder proposal that asked Cisco’s manage- ment to pay out its large cash reserves to shareholders in the form of dividends (Cisco
currently has significant short-term assets, including cash and investment securities). The
sponsor of the proposal argued that it is the shareholders’ money and that it should be
distributed to them. The vote was nearly 10 to 1 against the proposal.
a. Does the outcome of this vote imply that the voting process is controlled by managers and that shareholders do not have a voice in the company? Explain.
b. The proponent of the proposal also asserts that management’s reluctance to pay dividends is related to the way they are compensated. Explain why this argument might be true.
Solutions to Self-Evaluation Problems 18–1. Shareholder Voting
No. While corporate voting is perfunctory in routine cases, it has been actively used in
certain cases to force change in an organization. For example, dissident shareholders can
engage in a proxy contest to elect nonmanagement supported board members. When these
contests are successful there is often a subsequent merger or restructuring that benefits
shareholders. Even if proxy contests don’t occur on a routine basis, the threat of a proxy
contest can help to discipline managers (recall the example of Chrysler Motors). The empir-
ical evidence suggests that proxy contests are an important governance mechanism that in-
creases shareholder value. Concentrated owners have incentives to take an active role in the
voting process. Recall the example of HP.
18–2. Cisco Shareholder Proposal
a. This outcome does not necessarily imply that the process is controlled by managers. It could be in the interests of shareholders for the company to maintain the cash
reserves. For example, Cisco might have potential investment options and the share-
holders might want the company to hold onto the cash to finance these options. Just
because one shareholder wants higher dividends does not make it value maximizing
to increase the payouts.
Self-Evaluation Problems
Suggested Reading
Chapter 18 Corporate Governance 613
b. Executive stock options are not usually dividend protected—the exercise price is not ad- justed for decreases in stock price that are due to dividend payments. Thus, an important
variable in valuing these options is the company’s dividend yield. Higher dividends re-
sult in lower option prices. Cisco executives receive a substantial part of their compen-
sation through stock options. Thus, they can have an incentive not to pay out dividends
(to maintain the value of these options).
18–1. What is a corporation? Describe the major characteristics of a large publicly traded corporation.
18–2. What incentive conflicts exist in corporations?
18–3. What mechanisms are used to address the incentive conflicts in corporations?
18–4. What costs do incentive conflicts in corporations generate?
18–5. Is it optimal to completely eliminate incentive conflicts in corporations through extensive monitoring and bonding activities? For example, is the optimal amount of corporate fraud
zero?
18–6. Do recent corporate scandals suggest that there are serious governance problems in most large corporations?
18–7. What are the three key objectives of corporate governance?
18–8. What is the “business judgment rule”? Discuss the economic logic for this legal precedent.
18–9. What are the major costs and benefits of organizing as a publicly traded corporation?
18–10. What are the primary sources of decision rights at the top of publicly traded corporations? Discuss the allocation of decision rights at the top of the typical U.S. corporation.
18–11. Why is it important to separate decision management and control in publicly traded corpo- rations? Discuss how a well-designed governance system achieves this objective.
18–12. Are the stock exchanges’ new rules relating to corporate boards of directors the answer to existing governance concerns in the United States?
18–13. What characteristics do you think are important in evaluating the quality of a corporate board?
18–14. What incentives, if any, do board members and management have to work in the interests of shareholders and the corporation?
18–15. Discuss how “market forces” help to reinforce internal governance systems.
18–16. What is the Sarbanes-Oxley Act of 2002 (SOX)? List its major provisions. Discuss the costs and benefits of the SOX and evidence on whether the net benefits have been positive
or negative.
18–17. What external parties monitor managers? Assess how these parties performed their roles in the 1990s. Discuss the current pressures on these parties.
18–18. Compare and contrast the key features of the traditional corporate governance systems found in the United States, Japan, and Germany.
18–19. Briefly discuss the effects and motives for recent changes and trends in corporate gover- nance in Europe and Japan.
18–20. What role does the SEC play in corporate governance in the United States?
18–21. What does it mean to “overpay” a CEO? Do you think that some CEOs are overpaid? What about the “typical” CEO?
18–22. Are stock options to blame for the earnings management scandals?
18–23. Have institutional investors been very active in the corporate governance process over the past 20 years? Which institutional investors have been the most active? Why?
18–24. What changes have been taking place in shareholder activism since the recent business scandals?
Review Questions
614 Part 4 Applications of Organizational Architecture
18–25. Have shareholder proposals been an important governance mechanism over the past 20 years? Do you see any changes occurring in today’s environment?
18–26. What is meant by cumulative voting, classified board, and voting by proxy?
18–27. What are the benefits and costs of corporate voting over the Internet? Do you think this type of voting will increase in the future?
18–28. What is a proxy fight? What potential effects do proxy fights have on managerial incen- tives?
18–29. Discuss why CEO succession planning is an important activity for the board of directors.
18–30. Describe the “passing the baton” approach to CEO succession. What other methods are used?
18–31. Is the likelihood of CEO turnover related to firm performance? Give several examples to support your position.
18–32. (Extended activity) Go to the SEC EDGAR Web site (www.sec.gov/cgi-bin/srch-edgar). Search for the recent SEC filings of a publicly traded company (such as Walmart Stores
Inc.). Review the firm’s most recent proxy statement (form DEF 14 A). Summarize and
evaluate the firms’ board of directors (composition, committee structure, etc.) and execu-
tive compensation policies.
18–33. Suppose you were to estimate a statistical model explaining the relation between the degree of ownership concentration and the following variables: (1) the degree of regulation in the
industry, (2) firm size, and (3) stock price volatility. Predict the signs on each of these vari-
ables and explain the logic for your predictions.
The Appendix to Chapter 18, “Choosing among the Legal Forms of Organization,” can be found via McGraw-Hill Connect®. For more information, refer to the Preface.
Web Appendix: Choosing among the Legal Forms of Organization
chapter
19 C H A P T E R O U T L I N E
Vertical Chain of Production
Benefits of Buying in Competitive Markets
Reasons for Nonmarket Transactions
Contracting Costs
Market Power
Taxes and Regulation
Other Considerations
Vertical Integration versus Long-Term Contracts
Incomplete Contracting
Ownership and Investment Incentives
Specific Assets and Vertical Integration
Asset Ownership
Other Reasons
Continuum of Choice
Contract Duration
Contracting with Distributors
Free-Rider Problems
Double Markups
Regulatory Issues
Trends in Outsourcing
Summary
Appendix: Ownership Rights and Investment Incentives
I n 1983, Apple Computer executives bragged that the Macintosh was a “machine that is made in America.”1 A few years later while he was managing NeXT Computer, Steve Jobs asserted, “I am as proud of our factory as I am the computer.” As late as 2002, top Apple executives
would drive about two hours to visit the company’s iMac plant in Elk Grove, California. Today in 2014, Apple does almost no manufacturing or assembly “in house.” Rather it outsources the manufacturing and assembly of its mil- lions of iPhones, iPad’s, and computers to outside and mostly foreign com- panies. Many of these outside companies provide services to other compa- nies, some of which compete with Apple. For example, Foxconn—the large Taiwanese multinational that assembles iPhones—manufactures products
Vertical Integration and Outsourcing
L E A R N I N G O B J E C T I V E S
1. Identify what the vertical chain of production is for a particular industry. 2. Discuss the benefits of purchasing inputs and downstream services in competi-
tive markets.
3. Explain how contracting costs, market power, taxes/regulation, and other consid- erations can motivate firms to acquire inputs and downstream services through
nonmarket transactions.
4. Describe the major factors that determine whether it is better for a firm to vertically integrate or to obtain inputs and downstream services from other firms
through long-term contracts.
5. Define the term firm-specific assets and explain why they can cause problems in contracting with outside suppliers and distributors.
6. List and explain the major determinants of the optimal contract length. 7. Discuss how free rider problems can arise when contracting with multiple inde-
pendent distributors and how various contract provisions can be used to reduce
these problems.
8. Explain the double-markup problem and how various contract provisions can be used to address it.
9. Describe the underlying factors that have motivated the observed trends in outsourcing over the past few decades.
1Sources for the motivating examples in this section include, C. Duhigg and K. Bradsher (2012),
“How the U.S. Lost out on iPhone Work,” New York Times (January 21); and Special Report: Outsourcing and Offshoring (2013) “Here, There and Everywhere,” The Economist (January 19), 4.
616 Part 4 Applications of Organizational Architecture
for other tech firms, such as Blackberry, Kindle, PlayStation 4 and Xbox One. The typical U.S. manufacturer across all industries now outsources between 70 and 80 percent of its finished product. “Crucial semiconductors” inside the iPhone 4 and 4S are manufactured in Austin, Texas in a factory owned by one of Apple’s primary competitors, Samsung of South Korea. Outsourcing is not limited to manufacturing. Companies spend billions of dollars annually to acquire a wide range of services and products from other companies, including data processing, catering, copying, call centers, advertising, bookkeeping/payroll, transportation, security, janitorial ser- vices, refuse collection, and software testing.
While companies outsource many activities, they perform others in-house using their own employees and assets. For example, Apple owns a large chain of retail stores staffed by company employees, and its U.S. employees perform most of the company’s product and software development, as well as design and marketing func- tions. Apple recently built a $500 million data center in North Carolina.
Firms change their outsourcing decisions over time. Prominent U.S. companies, such as Google, General Electric, Caterpillar, and Ford Motor Company, recently have “re-shored” various activities that they previously had outsourced to foreign suppliers by bringing production back to America. In December 2013, Apple said that it would start making a line of its Mac Computers in America. Some of these companies are bringing activities back in-house; in other cases they are outsourcing them to outside companies operating in the United States. Lenovo, which by some measures is now the biggest PC-maker in the world, recently opened a plant in Whitsett, North Carolina. Lenovo is a highly successful Chinese technology com- pany, which bought IBM’s ThinkPad PC business in 2005.
Outsourcing involves a fundamental change in organizational architecture. First, it reassigns decision rights relating to certain assets and employees from one firm to another. For example, Foxconn owns the dozens of facilities in Asia, Eastern Europe, Mexico, and Brazil that assemble an estimated 40 percent of the world’s consumer electronics for customers such as Amazon, Dell, Hewlett Packard, Motorola, Nintendo, Samsung, and Sony. Foxconn retains all of the decision rights at these plants that are not specified in their contracts with other companies or by law. Second, compensation and performance-evaluation systems generally change with outsourcing. The Foxconn factory in China, which assembles iPhones, employs around 230,000 people. In comparison to Apple employees in the United States, Foxconn expects its employees to work longer hours each week. While compensa- tion is much lower in China, employees live in company provided barracks and over the past few years have been paid about $17 a day. Some pay raises have been conditional on the employee passing a three-month performance evaluation.
This discussion of outsourcing raises a number of important questions:
• What are the costs and benefits in choosing between the alternative architec- tures that are implied by within-firm production versus outsourcing?
• What activities are most likely to be outsourced? Why are functions such as manufacturing, data processing, catering, copying, and trucking among the more frequently outsourced services? Why does Apple maintain ownership of assets that are used on-site by some of their outsourcing partners?
• When a company outsources, what are the determinants of the specific con- tract provisions? Why might a company negotiate a 10-year contract instead of a 1-year contract? Why do some firms grant distributors exclusive rights to particular territories?
Chapter 19 Vertical Integration and Outsourcing 617
• What has motivated the trend in increased outsourcing over the past few decades and why have some major companies recently brought various functions back to the United States?
We begin by discussing the process of producing and marketing products. We then discuss trade-offs among alternative ways of organizing the steps in this process (market transactions, long-term contracts, and vertical integration), the appropriate length of a contract, contracting with independent distributors, and reasons for the recent increases in outsourcing. In the appendix to this chapter, we provide a more detailed example that highlights some of the trade-offs between company ownership and outsourcing.
Vertical Chain of Production Consumer goods are produced through a series of steps described by the vertical chain of production.2 Figure 19.1 depicts this vertical chain for personal computers. At the top of the chain are the raw materials such as chemicals, metals, and rubber that are used as inputs to produce PCs. These inputs are transported to processors that make the intermediate products used in the final construction of PCs (for instance, plastics manufacturers, chip makers, and operating software producers). The interme- diate goods are transported to companies that assemble them into PCs. Finally, the
2D. Besanko, D. Dranove, and M. Shanley (1995), The Economics of Strategy ( John Wiley & Sons: New York), 71.
Steps in the vertical chain Support services
Accounting
Finance
Human resources
Legal
Marketing
Other support services
1. Raw materials (chemicals, metals, rubber) 2. Transportation and storage 3. Intermediate-goods processors (plastics, chips, operating software) 4. Transportation and storage 5. Assemblers (PC manufacturers) 6. Transportation and storage 7. Retailer distribution and service (computer stores)
Figure 19.1 The Vertical Chain of Production for Personal Computers
At the top of the chain are the raw materials, such as chemicals, metals, and rubber, that are used as inputs to produce PCs. These inputs are transported to intermediate-goods processors. These processors (for instance, plastics manufacturers, chip makers, and operating software producers) make the intermediate products used in the final construction of the PCs. These intermediate goods must be transported to the companies that assemble them into the final consumer products. These products then are transported to retail stores, which sell them to consumers. Each step of the vertical chain is supported by administrative services such as accounting, finance, and marketing.
618 Part 4 Applications of Organizational Architecture
PCs are transported to retail stores, which sell them to consumers and provide after- sales servicing. Each step of this vertical chain is supported by administrative services such as accounting, finance, and marketing. Firms can locate at different positions along the vertical chain. Intel is an intermediate-goods processor that manufactures computer chips; Dell Computers sells PCs and concentrates on final assembly and distribution. Firms also can specialize in providing support services (for instance, shipping and accounting firms).
When a firm participates in more than one successive stage in the vertical chain, it is said to be vertically integrated. Firms vary dramatically in their degree of verti- cal integration. Dell Computers leases much of its manufacturing space and makes virtually none of its component parts. It does not make or even stock the many soft- ware products that it sells. IBM historically has been much more vertically inte- grated, producing many of its component parts and much of its software in-house. IBM also maintains its own sales force for mainframe computers.
Firms change their degree of integration over time. An organization that begins to produce its own inputs is engaging in backward, or upstream, integration, whereas an organization that begins to market its own goods or to conduct additional finish- ing work is engaging in forward, or downstream, integration. Lincoln Electric integrated backward when it began manufacturing certain inputs for its welding machines that previously were supplied by outside companies. Apple integrated forward when it opened Apple stores to sell its desktops, laptops, and iPods.
The term outsourcing frequently is used to describe a movement away from vertical integration—moving an activity outside the firm that formerly was done within the firm. An example of this usage is “Manulife outsourced its computer operations to IBM in 2011 in a seven-year $665 million deal.” The term outsourcing also is used to describe an ongoing arrangement whereby a firm obtains a part or service from an ex- ternal firm. An example of this usage is “Reebok always has outsourced most of its footwear production to foreign companies.”
M A N A G E R I A L A P P L I C AT I O N S
Long-Term Contracts In this chapter, we generally do not differentiate among various types of long-term contracts. Rather, we focus on how
firms choose among spot markets, contracts, and vertical integration. Long-term contracts, however, can take a variety
of forms. First, there are standard supply and distribution contracts between independent firms. For instance, in 2014 EMCOR entered into a new, multiyear contract to supply Coverglass Interconnected Cells to Lockheed Martin for its
satellite program. The typical long-term contract contains many provisions specifying the nature of the service and the
duties and obligations of each of the contracting parties. Second, there are joint ventures. In the typical joint venture, a new firm is formed that is jointly owned by two or more independent firms. The new firm might be responsible for
conducting research, supplying inputs, or downstream activities such as marketing or distributing a product. Drug
companies form research joint ventures to conduct basic research on new drugs. The output of this research is shared
by the partners in the venture. Similarly, an American company and a European company might form a joint venture to
market the American company’s products in Europe. Third are lease contracts, where a firm acquires an asset such as a machine or building through a lease agreement with another firm. Fourth are franchise agreements, which grant an independent businessperson the rights to use the parent’s proven name, reputation, and business format in a given
market area. Fifth are strategic alliances. This term is used to describe a variety of agreements between independent firms to cooperate in the development and/or marketing of products. For instance, an airline company and a car rental
company might agree to promote each other’s products and to participate in joint promotional activities.
Chapter 19 Vertical Integration and Outsourcing 619
Often it is useful to think of the outsourcing decision as a choice along a contin- uum of possibilities. As depicted in Figure 19.2, at one extreme, the part or service is purchased from any one of a large number of potential suppliers in the spot market (where the exchange is made immediately at the current market price with no long- term commitment between the buyer and the seller). At the other extreme, a company vertically integrates and produces the part or service internally.3 Between these extremes are long-term contracts between independent or quasi-independent firms. Long-term contracts take many forms, including long-term supply and distribution contracts, franchise agreements, leasing contracts, joint ventures, and strategic alliances. Many of the recent outsourcing decisions move the firm from vertical integration to long-term contracting (Manulife and IBM for various computer services, DuPont and Lanier for copying services). We begin our analysis of outsourcing by considering some of the advantages of acquiring parts and services in spot markets. We use the term market transactions to refer to sales and purchases in the spot market; we use the term nonmarket transactions to refer either to vertical integration or to long-term contracts.
Spot markets Long-term contracts Vertical integration
Figure 19.2 Outsourcing: Choosing along a Continuum
It often is useful to think of the outsourcing decision as a choice along a continuum of possibilities. At one extreme, a product or service can be purchased from any one of a large number of potential suppliers in the spot market. At the other extreme, the company can produce the product or service internally within a division of the vertically integrated firm. Between these extremes are various long-term contracts. Contracts take a variety of forms, including standard supply and distribution contracts, joint ventures, lease contracts, franchise agreements, and strategic alliances.
M A N A G E R I A L A P P L I C AT I O N S
Vertical Outsourcing by Taiwan Semiconductor For years electronic companies like Motorola produced most of their chips to “in-house” to control quality and design.
By 2002 Motorola had outsourced a substantial fraction of the chips it used. In that year, Taiwan Semiconductor
Manufacturing Co. (TSMC) and Motorola announced an expanded outsourcing program wherein TSMC would double
its chip manufacturing capacity by 2006. In the late 1990s, TSMC obtained most of its revenues from chip
manufacturing. Since then TSMC has vertically integrated additional design and manufacturing services to get
customers to outsource both these functions. In 2013, TSMC recorded $20 billion in sales compared to only $1.5
billion in 1999. Its outsourcing customers include one of the world’s leading semiconductor and system companies
(e.g., Advanced Micro Devices), as well as integrated devices manufacturers, such as Texas Instruments.
Source: J. Moore (1999), “TSMC’s Chip Business Booms as More Companies Outsource,” BusinessWeek (June 21), 128; Motorola.com (June 26, 2002); and TSMC (2014), SEC Form 20-F (April 14).
3See Chapter 17 for a discussion of how firms organize internal production into divisions and the
corresponding transfer-pricing issues.
620 Part 4 Applications of Organizational Architecture
Benefits of Buying in Competitive Markets Figure 19.3 presents the standard diagram of a competitive equilibrium. The figure illustrates that competitive markets result in efficient production: Production occurs at the lowest possible average cost per unit. Price equals average cost, implying that buyers acquire the product at cost (which of course includes a normal rate of return on investment).4 Over time, suppliers adopt technological advances that lower the costs of production and/or enhance the quality of the product. Lower costs are passed to buyers in the form of lower prices. This analysis suggests that when competitive outside markets are available to purchase goods and services, firms should use them. In most cases, a firm cannot acquire the product more cheaply through a nonmarket transaction; in many cases, it would cost more.
One common concern with internal production is generating sufficient volume to take advantage of scale economies in production. In Figure 19.3, the minimum point on the average cost curve is at a volume of Q* units. Individual firms in the marketplace produce this volume. If a firm requires less than Q* units and produces only that amount internally, it will incur higher average costs. The firm could produce Q* and sell the surplus in the open market. However, this choice requires the firm to
$ $
P* P*
P ri ce
a n d c
o st
p e r
u n it
o f o u tp
u t
(i n d
o lla
rs )
Qi Q* Q*
Q
Quantity of outputQuantity of output (firm i)
IndustryFirm
D
S
LRMC LRAC
i
Figure 19.3 Competitive Equilibrium
This figure illustrates that competitive markets result in efficient production. The right panel displays the supply-and-demand curves for the industry. Their intersection determines the market price. The left panel pictures the output decision of the marginal firm in the industry. Production occurs at the lowest-possible long-run average cost (LRAC). Buyers acquire the product at cost (P* � LRAC � LRMC, where LRMC � long-run marginal cost). The analysis suggests that when competitive outside markets for inputs are available, firms should use them. In most cases, the firm cannot produce more cheaply itself, and in many cases it will cost more.
4Recall that if price is above long-run average cost, firms are making economic profits and new firms enter the
industry. The increase in supply drives down the price. Alternatively, if price is below long-run average cost,
firms are losing money and exit occurs.
Chapter 19 Vertical Integration and Outsourcing 621
enter a new market—one that is not its primary line of business. Diversifying into unrelated fields can reduce value. Empirical studies suggest that diversified firms frequently perform poorly relative to firms that are more focused.5
Another concern with nonmarket procurement is the cost of motivating efficient production. Divisions within large firms can be inefficient, yet continue to survive, so long as they are subsidized by more profitable units within the firm. Firms must adopt costly incentive and control systems to motivate internal managers to engage in efficient production. Similarly, parties to a long-term supply contract must be mo- tivated to carry out their parts of the agreement. Independent firms, on the other hand, face more direct market pressures. If they are inefficient in their main line of business, they lose money and eventually are forced to liquidate.
Due to such concerns, most firms use markets to acquire many, if not most, of their inputs. Few companies produce their own trucks, fuel, copy machines, pencils, staples, telephones, office furniture, or bathroom fixtures. Most of these products are acquired through market transactions. Also, firms generally rely on external markets for many of their downstream activities, such as product distribution. For instance, Procter & Gamble sells many of its products, such as soap and toothpaste, through independent grocery stores and drugstores. The key point is that well-functioning markets provide powerful incentives for efficient production and low prices. It is value-maximizing to acquire many goods and services through market transactions.
Reasons for Nonmarket Transactions Our analysis might appear to argue against nonmarket transactions: Firms should concentrate on a particular stage of the production/distribution process and acquire other inputs and services using market transactions with outside suppliers and distributors. There are, however, at least three potentially important reasons why firms use nonmarket transactions to acquire inputs and downstream services: contracting costs, market power, and taxes/regulation.
Contracting Costs
We have discussed the architecture of markets. We argued that markets effectively link specific knowledge and decision rights; moreover, they provide incentives for decision makers to use this information effectively. We posed the question: Why aren’t all economic transactions conducted through markets? Ronald Coase pro- vided the basic answer to this question by arguing that market transactions are not costless.6 For instance, they involve the costs of searching for trading partners and negotiating relevant prices. Parties to a transaction have incentives to use other mechanisms, such as internal production, when the transaction can be accomplished at a lower cost. At least four factors can make the costs of nonmarket transactions
5P. Berger and E. Ofek (1995), “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37, 39–65; R. Comment (1995), “Corporate Focus and Stock Returns,” Journal of Financial Economics 37, 67–87; and K. John and E. Ofek (1995), “Asset Sales and Increase in Focus,” Journal of Financial Economics 37, 105–126.
6For a collection of Coase’s 1991 Nobel-Prize winning work on this topic, see R. Coase (1988), The Firm, the Market, and the Law (University of Chicago Press: Chicago).
622 Part 4 Applications of Organizational Architecture
lower than the costs of market exchanges. These factors include firm-specific assets, costs of measuring quality, externalities, and coordination problems.
Firm-Specific Assets7
Production typically requires investment in assets. As examples, IBM requires main- frame computers to provide computer services to other companies and suppliers re- quire machines to make parts. Sometimes these assets can be transferred easily among alternative uses. Mainframe computers are general-purpose machines that can be used to serve a variety of companies. Other assets are significantly more valu- able in their current use than in their next best alternative. For example, the Alaska Pipeline is materially more valuable for transporting oil than for any other conceiv- able use. If IBM writes a specialized computer program to run a given company’s payroll, the program is more valuable for that firm’s payroll than for some other firm’s payroll (which might offer different fringe benefits, for instance). Although the program could be adapted for use by other firms, changing the program is costly. Assets that are substantially more valuable in their current use than in their next best alternative use are referred to as firm-specific assets. Asset specificity is most likely to occur in four particular instances.8
• Site Specificity. The asset is located in a particular area that makes it useful only to a small number of buyers or suppliers, and it cannot be moved easily. An example is the Alaska Pipeline, which can be used only by oil producers on Alaska’s north slope.
• Physical-Asset Specificity. Product design makes the asset especially useful only to a small number of buyers. An example is a specialized machine tool that is used to make parts for one particular model of automobile.
M A N A G E R I A L A P P L I C AT I O N S
Made in the USA Companies sometimes label their products “Made in the USA.” This statement apparently appeals to the sentiment
among some consumers that Americans should purchase only American-made products to protect domestic jobs. The
claim also helps companies gain contracts from the U.S. government. The common practice of acquiring many inputs
from outside suppliers, however, makes it difficult to define what really is made in the USA. For example, today an
“American” car sold in Chicago could have rolled off an assembly line in Tennessee with parts made in dozens of
different countries.
The Federal Trade Commission (FTC) is charged with policing firms for false or misleading claims about the
country of origin. Defining the country of origin, however, is very difficult in practice and that is why it takes the FTC
40 pages to try to explain the rules. According to the FTC, a California radio manufacturer can claim its product was
made in America even though it has a plastic case made from imported oil. Similarly, so can a computer maker in
Texas, that is, building a PC from American made parts that include a disk drive with a case made from steel imported
from overseas. However, a wrench produced in Ohio with steel imported from Korea, cannot be labeled as made in
America because the steel represents a “significant cost” of production. The rules are somewhat ambiguous to say the
least. The FTC typically warns a first-time offender that it believes is making a misleading claim. If the company
“breaks the rules again” is likely be hit with a large fine for each infraction.
Source: J. Schoen (2010), “Made in America’ rules are complex, confusing,” NBCNEWS.com (March 15).
7This section draws on B. Klein, R. Crawford, and A. Alchian (1978), “Vertical Integration, Appropriable
Rents, and the Competitive Contracting Process,” Journal of Law & Economics 24, 297–326. 8O. Williamson (1985), The Economic Institutions of Capitalism (Free Press: New York).
Chapter 19 Vertical Integration and Outsourcing 623
• Human-Asset Specificity. The transaction requires specialized knowledge on the part of the parties to the transaction. An example is the knowledge that IBM employees must acquire about another company’s unique processes in order to provide computer services to the company.
• Dedicated Assets. The expansion in facilities is necessitated only by the re- quirements of a few buyers. An example is a chip producer who adds extra ca- pacity to serve one particular computer company.
If a supplier invests in a specific asset to serve a particular customer, that supplier places itself in a tenuous position for future negotiations. For example, consider a supplier who invests $50,000 for a machine tool (such as a metal punch-press die) to produce a particular part. The part is used only by one manufacturer, and the die has no other uses or salvage value—it is extremely firm-specific. The variable cost of production is $1 per unit and the useful life of the die is 50,000 units. The supplier must be able to sell the parts for at least $2 per unit to break even. The buyer, however, is in a strong position to argue for a price concession after the investment in the die is made. At this point, the investment is a sunk cost, and the supplier will continue to op- erate as long as it can cover its variable costs of $1 per unit. Thus, the buyer potentially can force the supplier to accept a price as low as $1, even though the supplier loses its initial investment. Anticipating this holdup problem, the supplier will not invest in the machine tool in the first place unless it receives some effective guarantee that the buyer will continue to pay at least $2 per unit and will buy 50,000 units.
Buyers face potential holdup problems as well if they purchase key inputs from a single supplier that has invested in the relevant firm-specific assets. For instance, a specialized chip supplier might demand a large price increase when it knows that a computer company has a large backlog of orders and that it has no alternative sources of supply.
These potential holdup problems can be controlled by vertical integration. If the buying firm invests in the machine and produces the part internally, it does not have to worry about subsequent renegotiations with its supplier over prices. An alternative to integration would be for the buyer and supplier to enter into a long-term supply contract. The buyer might agree to purchase 50,000 units from the supplier over the next five years at a cost of $2.10 per unit. Contracts are not costless to write or to en- force, and so the preferred alternative depends on the relative costs of vertical inte- gration versus contracting. This trade-off is considered in greater detail below.
Measuring Quality It is difficult to monitor the quality of some inputs and services. The buyer might not be able to learn that a part is defective until long after purchase. In such cases sellers can have the incentive to cheat buying firms: Once a price is set, a supplier can in- crease its profits by supplying a lower-quality, lower-cost product. Buyers sometimes can avoid these problems by transacting with companies that have established reputa- tions for quality and/or can offer credible warranties for their products. Otherwise, buyers either should negotiate a long-term supply contract that provides appropriate incentives for quality production or should produce such products in-house. Internal production and long-term contracts are especially useful when maintaining the qual- ity of the part is critical for the overall success of the product. These nonmarket forms of organization do not necessarily change the distribution of information among the parties. However, they allow the company to develop contractual incentives that mo- tivate quality production.
624 Part 4 Applications of Organizational Architecture
Controlling Externalities Firms often invest in developing reputations and customer loyalty. This investment can increase the demand for a company’s products. However, firms can have problems motivating independently owned distributors to invest sufficient resources to maintain a brand name—there is a free-rider problem. Independent retailers in a distribution sys- tem have incentives to shirk on advertising and depend on the efforts of other units in the system to attract customers. These retailers also might want to cut costs by hiring less skilled, lower-priced labor. A given owner of a retail unit receives all the benefits from reducing the unit’s labor costs but bears only part of the costs from providing poor service to customers: Any decline in future sales is likely to be shared with other units. The incentives to free-ride are particularly large when the retailer deals with customers who are not likely to make repeat purchases at the particular unit.
This free-rider problem can be controlled either through vertical integration, where managers of stores are compensated in ways that discourage free-riding, or through long-term contracts with terms that motivate increased sales efforts. We provide a more detailed discussion of such distribution contracts later in this chapter.
Extensive Coordination Some activities require extensive coordination. For example, railroads rely on exten- sive feeder traffic for their routes. In principle, it would be possible to use the price system for each link within this network. Rail companies could pay one another to use their lines, with prices adjusting to changes in supply and demand. But such a system would be complicated and expensive to operate. An alternative is for the rail- road companies in the network to merge and to manage the various coordination problems internally. Railroad companies were among the first large firms in the United States. These large firms were motivated, at least in part, by the benefits of using internal managers, rather than market transactions, to coordinate rail activity.9
A related reason for vertical integration is to coordinate pricing and service decisions among retail units. The pricing decisions of individual retailers can have effects on other units in the system—they produce a kind of externality. For instance, it might be optimal from a companywide standpoint to set prices where some units sustain losses. (When McDonald’s stays open, customers are less likely to try Burger King.) Independent retailers cannot be expected to set optimal systemwide prices since they care only about the profits from their own units. In principle, the central company could set the retail prices; but antitrust law limits this solution. The company can coordinate prices if it owns its retail outlets.
Market Power
A firm with market power might use vertical integration to increase profits in several different ways. The following example illustrates one of these methods—using ver- tical integration to price-discriminate.10 Consider a firm, DrugCo, that has a patent on a particular chemical compound used as an input in the production of two different pharmaceutical products. One of the products is a pain reliever that competes with many other pain relievers. The other helps cure a particular type of
9A. Chandler (1977), The Visible Hand—The Managerial Revolution in American Business (Belknap Press: Cambridge). Also, D. Carlton and M. Klamer (1983), “The Need for Coordination among Firms with Special
Reference to Network Industries,” University of Chicago Law Review 50, 446–465. 10For additional methods, see Carlton and Perloff (1990), Chapter 6.
Chapter 19 Vertical Integration and Outsourcing 625
cancer and faces no close substitutes. The industry demand for the two retail prod- ucts (pain reliever and cancer drug) is given by
Pain relief: P � 100 � 5Q (19.1) Cancer drug: P � 200 � 10Q (19.2)
The marginal cost to DrugCo for producing the chemical compound is $10 per gram. For simplicity, suppose that a drug manufacturer can take the chemical compound and transform it into 1 gram of either retail product (pain reliever or cancer drug) at zero marginal cost incurring no additional distribution or marketing costs. Many manufacturers can produce and distribute the retail drugs. Competition among these retail manufacturers will drive the retail prices of the pain reliever and cancer drug down to the retail manufacturers’ marginal costs, which in this example is the whole- sale price of DrugCo’s chemical compound. Thus, the demand curves facing DrugCo at the wholesale level are the same as the retail demand curves given in Equations (19.1) and (19.2).
To maximize total profits, DrugCo would like to set marginal revenue equal to mar- ginal cost in each market. As shown in Figure 19.4, the optimal price to charge retail drug manufacturers who produce the pain reliever is $55. The optimal price for those who produce the cancer drug is $105.11 Since both retail markets are competitive and
Output
Pain reliever
MR D MC
$
100
P ri ce
a n d c
o st
p e r
g ra
m (i n d
o lla
rs )
55
Cancer drug
MR MC
D
Output
$ 200 200
105
10 10 Q Q
Figure 19.4 Using Vertical Integration to Price-Discriminate
DrugCo has a patent on a chemical compound used as an input in the production of two different pharmaceutical products: a pain reliever that competes with many other products and a cancer drug. The marginal cost to DrugCo for producing the chemical compound is $10 per gram. The industry-level demand curves for the two products are the same demand curves facing DrugCo for the chemical compound. The optimal price to charge manufacturers who produce the pain reliever is $55. The optimal price for those who produce the cancer drug is $105. However, if DrugCo tries to sell to some companies at $55 and others at $105, potential arbitrage is available. One way to price-discriminate effectively is for DrugCo to integrate forward into the retail market for pain relievers. It would sell the pain reliever to consumers at $55 and the chemical compound to the manufacturers of the cancer drug at $105.
11Recall from Chapter 7 that these prices are easily found by setting the marginal revenue in each market
(implied by the two demand curves) equal to the marginal cost of $10.
626 Part 4 Applications of Organizational Architecture
there are no other costs, the price to consumers in the two markets would be $55 and $105. However, if DrugCo tries to sell to some manufacturers at $55 and other man- ufacturers at $105, potential arbitrage is available: Manufacturers who buy at $55 can resell the chemical compound to other manufacturers at less than $105 and make a profit. They will undercut any attempt by DrugCo to sell to manufacturers at $105.
One way that DrugCo can prevent such arbitrage is to integrate forward and man- ufacture the pain reliever. The company would price the pain reliever at $55 in the re- tail market and sell the base drug at $105 in the wholesale market. Arbitrage is no longer possible (assuming that the pain reliever cannot be transformed back into the chemical compound at low cost). Integrating forward into the retail market for the cancer drug will not solve the problem. If DrugCo tries to price the cancer drug at $105 and sell the chemical compound at a wholesale price of $55, other retail man- ufacturers would begin to produce and market the cancer drug (after buying the chemical compound at $55) and assuming DrugCo does not have a patent for the process of producing the cancer drug. DrugCo would not be able to maintain a price of $105. It must integrate forward into the lower-priced (more elastic) pain- reliever market.
Taxes and Regulation
Taxes and regulation also can motivate vertical integration. If the profits of one stage of production are heavily taxed and those of another are not, total taxes might be re- duced by shifting profits to the low-tax activity. A firm potentially can capture these gains by integrating vertically and having the low-tax unit charge higher transfer prices to the high-tax unit. Tax authorities are aware of this incentive and limit this type of activity.12
Similarly, a regulated company might want to integrate vertically to shift prof- its from a regulated segment of the business, where profits are restricted, to an unregulated segment of the business. In 1984, AT&T settled an antitrust suit with the Department of Justice by splitting into several firms. One of the concerns of the
M A N A G E R I A L A P P L I C AT I O N S
Price Discrimination and Antitrust Law Firms that integrate vertically to engage in price discrimination sometimes can be held accountable under antitrust law.
Alcoa had market power in the production of virgin aluminum ingots, an intermediate good. It integrated into the
lower-priced markets (e.g., rolled sheet) and “squeezed” competitors in these markets. The judge who wrote the
opinion in the antitrust case proposed a “transfer-price test” to assess whether a firm is engaged in a price squeeze. The
test considers whether the integrated firm could sell the final output profitably at prevailing prices, assuming it had to
pay the same price for the input as it charges downstream competitors. The court determined Alcoa could not.
(Note that in our example from the previous section, DrugCo would operate at a loss if it paid $105 for the input and
sold the pain reliever to consumers at $55.)
Source: United States v. Aluminum Company of America (1945), 148 F. 2d, 416.
12M. Scholes, M. Wolfson, M. Erickson, E. Maydew, and M. Hanlon (2011), Taxes and Business Strategy: A Planning Approach, 4th Edition (Prentice Hall: Englewood Cliffs), Chapters 10–11.
Chapter 19 Vertical Integration and Outsourcing 627
Justice Department was that it was difficult to monitor cost-shifting among AT&T’s regulated businesses (e.g., telephone service) and other less regulated businesses (for instance, telephone equipment). The breakup of AT&T reduced these concerns.13
Other Considerations
Another potential motive for nonmarket procurement is to ensure the supply of an important input. In contrast to the standard economic model, shortages sometimes occur in actual markets. For example, theaters do not always raise ticket prices for popular movies. Rather, tickets are allocated on a first-come, first-served basis when demand exceeds theater capacity for a performance. Similarly, companies some- times face rationing or short supply of particular inputs. Companies might integrate vertically or enter long-term contracts to increase the reliability of receiving an input.
Firms also use nonmarket procurement to avoid sharing proprietary information with other firms. For instance, a firm might be reluctant to provide an independent supplier with detailed information about its production processes because it fears that the supplier might share the information with other firms. Normally, it is easier to control the leakage of sensitive information when dealing with internal employees or long-term suppliers.
Another common explanation for nonmarket transactions relies on technologi- cal factors. For example, some people explain the common ownership of steel milling and steel production by the close technological links of the two processes. But this argument is flawed. Although it is true that there are benefits from having these operations at one location, technology does not dictate ownership. In princi- ple, a steel mill could buy hot steel ingots from other companies located in the same building. The reasons it does not are due not to technological factors, but rather result from contracting problems: Independent companies do not want to expose themselves to potential holdup problems that arise from such firm-specific investments.
Vertical Integration versus Long-Term Contracts14
We have discussed reasons why a firm might acquire a good or service through a nonmarket transaction. We now consider the trade-offs between the two general types of nonmarket transactions, vertical integration and long-term contracts. We examine these trade-offs using the example of AutoCorp, a producer of new automobiles. AutoCorp is considering whether to produce its own auto bodies or to obtain them from an independent supplier through a long-term contract. In either case, a new auto body plant must be constructed. There will be ongoing production, maintenance, and capital-replacement costs. AutoCorp wants to choose the organi- zational arrangement that maximizes value.
13D. Carlton and J. Perloff (1990), Modern Industrial Organization (HarperCollins: New York). 14This section draws on Williamson (1985). Important references on this topic include Klein, Crawford, and
Alchian (1978); S. Grossman and O. Hart (1986), “The Costs and Benefits of Ownership: A Theory of
Vertical and Lateral Integration,” Journal of Political Economy 94, 691–719; and O. Hart (1995), Firms, Contracts, and Financial Structure (Oxford Press: Oxford).
628 Part 4 Applications of Organizational Architecture
Incomplete Contracting
If contracts were costless to plan, negotiate, write, and enforce, it would not matter if AutoCorp made its own auto bodies or bought them from an outside supplier. In either case, a complete contract would be negotiated, one that specified exactly what was expected of each party under all possible future contingencies. Severe penalties would ensure compliance. The actions of each party would be chosen to maximize value (the level of investment, ongoing expenditures, production quantities, designs, and so on). With vertical integration, the contracts would be between the firm and employees, whereas a long-term supply contract would be between two independent firms.
Contracting, however, can be expensive. First, it is difficult to foresee and plan for all possible contingencies. AutoCorp surely will want to make future changes in the design of its auto bodies if customer tastes change or if a competitor develops a su- perior body design. However, AutoCorp’s managers are unlikely to know the appro- priate response until the new situation actually confronts them. Second, it is expen- sive to negotiate contracts. Self-interested parties often find it difficult to agree on contracts—consider the record of strikes by professional athletes. Third, it is costly to enforce contracts. Contracting costs necessitate incomplete contracts: Many con- tingencies will be omitted and thus left open for future negotiation. For example, some IBM outsourcing contracts state that IBM must maintain a state-of-the-art data center. The exact technology, software, and communications system are rarely specified. When contractual disputes arise, the contracting parties are likely to incur legal expenses and spend valuable time either preparing for court or renegotiating contracts.
The prospect of future negotiations can motivate suboptimal investment. Parties to the contract realize that part of the gains from their investments (in capital or effort) are likely to go to other parties: They are not protected by a complete contract. For example, as we discuss below, a supplier will be reluctant to invest effort or capital to reduce production costs if the buyer is likely to capture most of the gains by renegotiating a lower purchase price for the input.
Ownership and Investment Incentives
The owner has the right to determine the residual use of an asset—any use that does not conflict with prior contract, custom, or law. Residual rights give an individual in- creased ability to capture the gains from an investment and can affect investment in- centives. For instance, house owners have the residual rights with respect to their properties. As long as their actions are consistent with the law and existing contracts (e.g., zoning requirements and restrictive covenants in the deed), they are free to sell or rent their houses. The ability of owners to capture the gains from investing in house repairs through higher selling prices makes it more likely that owners will take better care of houses than renters. Renters are reluctant to invest in repairs if much of the gains goes to owners.15
15C. Smith and L. Wakeman (1985), “Determinants of Corporate Leasing Policy,” Journal of Finance 40, 896–908.
Chapter 19 Vertical Integration and Outsourcing 629
Vertical integration and long-term contracts differ in their assignment of owner- ship rights. Vertical integration keeps the ownership rights for the relevant assets within one firm, whereas long-term contracting apportions them between firms. As we discuss below, the optimal choice between vertical integration and long-term contracts depends, at least in part, on which ownership structure motivates the most productive investment decisions.
Specific Assets and Vertical Integration
Specific assets can cause substantial investment distortions among independent contractors. Consider the investment incentives of BodyWorks, a potential supplier to AutoCorp. BodyWorks would have to construct a plant next to one of AutoCorp’s major production facilities. Transportation costs and special designs make this plant quite specific: It is of much less value to other car companies that are farther away and use different body designs. Asset specificity places BodyWorks in a tenuous position. Without the guarantee of a complete contract, BodyWorks will be con- cerned that AutoCorp will try to lower the price for auto bodies once the investment is made (recall from Chapter 5 that BodyWorks has incentives to operate as long as price is greater than average variable cost). AutoCorp might claim that BodyWorks is supplying low-quality products and demand a price concession. Given litigation costs, BodyWorks might be forced to accept the lower price. This concern reduces BodyWorks’ incentives to invest in the plant. Similarly, AutoCorp might be reluctant to tailor-make their cars to fit BodyWorks products because it fears that BodyWorks will be opportunistic and increase the price for its auto bodies. In this example, investment incentives can be improved through vertical integration. If AutoCorp constructs its own auto body plant (or buys BodyWorks), it is in a position to capture the gains from its investment. It does not have to worry that some outside firm will try to extract part of the returns by demanding a different price for auto bodies. Other contracting costs might decline as well, since the companies do not have to negotiate a complicated legal contract.
Looking at the history of the U.S. auto industry suggests that this is, in fact, what happened. Originally, an automobile manufacturer would sell their customer an engine and transmission mounted on a frame with tires and wheels. The customer
M A N A G E R I A L A P P L I C AT I O N S
Renting and Asset Abuse Renters do not bear the total costs from abusing an asset, since it is owned by the rental company; thus, rental assets
frequently are abused. “In one case, a fellow rented a sports car with 12 miles on it. He took out the high-powered
engine and installed it in a ‘stock car,’ to run a high-speed 500-mile race. After crossing the finish line, he reinstalled
the engine in the rental car and returned it. The rental company could not successfully prosecute because it failed to
establish the number of miles that had been put on the engine. The rental car still showed low mileage, and the rental
fee to the customer/car racer was only $24.” More recently, there have been a growing number of videos posted on
YouTube documenting extreme car rental abuse. Various companies now offer car rental companies GPS services
that help to track and report on unwanted driving styles, including certain types of abuse that previously were difficult
to detect.
Source: D. McIntyre (1988), “Rent a Reck,” Financial World (September 20), 72; GPS Systems (2014), “Top 5 Car Rental Abuse Videos,” gpssystems.net.
630 Part 4 Applications of Organizational Architecture
would then take the automobile to a coach-works company to build the body and seats. General Motors (GM) decided it would be more efficient if the engine, frame, and body were designed and produced jointly. GM acquired Fisher, a prominent coach-works manufacturer, and made it the Fisher Auto Body Division of GM.
These arguments help explain why vertical integration can be preferred to long- term contracting. Why is this not always the case? What limits the entire economy from being served by one gigantic firm that produces everything? The answer lies again in investment incentives. Consider AutoCorp’s purchase of lightbulbs from LightCo. Since lightbulbs are not a specialized product, the purchasing arrangement harms neither LightCo’s nor AutoCorp’s investment incentives. LightCo is willing to make investments that reduce the costs of making lightbulbs because it benefits from these investments. If AutoCorp tries to capture some of the benefits from LightCo’s investment by offering a lower price for lightbulbs, LightCo simply will sell the bulbs to another customer. If LightCo tries to raise the price of its bulbs to extract profits from AutoCorp, it simply will buy bulbs from one of LightCo’s rivals, such as Philips Electronics or General Electric. In contrast, if AutoCorp purchases LightCo and operates it as an internal division, investment incentives might be distorted. As divisional managers, LightCo’s management might face reduced incentives to invest in innovative activities, since part of the credit for value-enhancing ideas will go to AutoCorp’s senior management. In addition, LightCo’s management might invest in unproductive activities, such as trying to influence senior management’s decisions (salaries, allocating capital to the divisions, and so on).16
These arguments suggest that the likelihood of vertical integration increases with the specificity of the asset. With less specialized assets, market transactions or long- term contracts are more likely to produce efficient investment incentives. This proposition is one of the most important ideas in the economic literature on organi- zations. Empirical tests support its validity. As an example, J. Stuckey examined alu- minum refineries that are located near bauxite mines.17 Not only are the refineries specific to particular mines owing to transportation costs, but the refineries also in- vest in specialized equipment. Stuckey found that in virtually all cases, there is ver- tical integration.
Research indicates that specific assets are especially likely to motivate integration in uncertain environments. In uncertain environments, the contracting problems with specific assets are particularly severe: It is nearly impossible to specify what actions each party should perform under all future contingencies. In more stable environments, the range of possible circumstances to cover is more limited and relatively complete contracts that mitigate relevant holdup problems can be negotiated at lower cost.
The arguments in this section are summarized in Figure 19.5. When asset speci- ficity is low, it is generally best to rely on market exchange, regardless of the level of uncertainty. As the degree of asset specificity increases, the desirability of nonmarket
16P. Milgrom and J. Roberts (1994), “Bargaining Costs, Influence Costs, and the Organization of Economic
Activity,” in J. Alt and K. Shepsle (Eds.), Perspectives on Positive Political Economy (Cambridge University Press: Cambridge), 57–89.
17J. Stuckey (1983), Vertical Integration and Joint Ventures in the Aluminum Industry (Harvard University Press: Cambridge). See also E. Anderson (1985), “The Salesperson as Outside Agent or Employee: A
Transaction Cost Analysis,” Marketing Science 4, 234–254; E. Anderson and D. Schmittlein (1984), “Integration of the Sales Force: An Empirical Examination,” Rand Journal of Economics 15, 385–395; and W. Kim, D. Mayers, and C. Smith (1996), “On the Choice of Insurance Distribution Systems,” Journal of Risk and Insurance 63, 207–227.
Chapter 19 Vertical Integration and Outsourcing 631
transactions increases. Uncertainty increases the desirability of vertically integrating firm-specific assets; when asset specificity and uncertainty are both high, vertical in- tegration is likely to be the preferred alternative.
This analysis of firm-specific assets helps explain why catering, trucking, copy- ing, and mainframe computing are among the more frequently outsourced services. These activities are sufficiently specialized that spot-market transactions are not vi- able. Nonetheless, these activities involve assets that are not highly firm-specific. Food-service equipment, trucks, copy machines, and computers can be used by many different companies; therefore, the potential for holdup actions is relatively low. Furthermore, for activities like copying, it is easy to write a relatively complete contract (uncertainty is reasonably low). There also are potential benefits from using independent firms that specialize in large-volume production. Moreover, the transac- tions are quite repetitive; thus, it makes sense to contract with a single supplier on a long-term basis. (The supplier makes customer-specific investments in learning how to serve the customer; hence, it is expensive to change suppliers.) These factors imply that it often is optimal to contract for these services.
One advantage of having IBM provide computer services to Manulife is that IBM provides similar services to other companies. This higher volume can lower the cost for Manulife. The costs of training technical specialists can be spread across more users; software can be written, that is, used by more than one company. Also, IBM is able to attract higher-quality computer specialists than can Manulife, since IBM’s scale of operation provides a much richer set of future career opportunities. Concep- tually, Manulife could capture some of these gains by purchasing IBM and operating the two companies as one large enterprise. However, the costs of managing such a large, diverse enterprise likely would outweigh the benefits.
Uncertainty
Low Medium High
Low Market Market Market transaction transaction transaction
Medium Contract Contract or Contract or vertical vertical integration integration
High Contract Contract or Vertical vertical integration integration
A s s e t
S p
e c if
ic it
y
Figure 19.5 Asset Specificity, Uncertainty, and the Procurement Decision
When asset specificity is low, it generally is optimal to use simple market transactions for procurement. As the degree of asset specificity increases, nonmarket transactions (contracts and vertical integration) become more desirable. When uncertainty is low, relatively complete contracts can be written. Thus, contracts can be used to resolve incentive conflicts motivated by firm-specific assets. As uncertainty increases, contracting becomes more expensive. Vertical integration of firm-specific assets becomes more likely as uncertainty increases.
632 Part 4 Applications of Organizational Architecture
Asset Ownership18
We have concentrated on potential holdup problems that occur after the initial invest- ment. Our major point is that these problems can be reduced through vertical integra- tion. However, common ownership can be achieved in our example either if AutoCorp owns BodyWorks or if BodyWorks owns AutoCorp. Which alternative, if either, is best? Considering ongoing specific investment provides a partial answer to this question. In their ongoing interaction, companies like AutoCorp and BodyWorks generally benefit from specific investments, which are difficult to observe or use as the basis for contracts. For example, the management of BodyWorks might invest in learning about AutoCorp’s future design plans so that it can plan more effectively for potential changes. This planning might increase the speed at which new models could be developed and thus improve overall corporate performance. Similarly, AutoCorp might invest in learning more about BodyWorks’ production processes to develop lower-cost body designs. Investments of this type are hard to observe and depend on the managers’ incentives to make them. These incentives, in turn, can depend on own- ership structure.
If AutoCorp buys BodyWorks it will structure BodyWorks as a division of the firm. The management of BodyWorks will be evaluated primarily on divisional per- formance and will have relatively low incentives to invest in activities that primarily
Vertical Integration in the Aerospace Industry Scott Masten was among the first to provide empirical evidence on the determinants of vertical integration by studying
the make-versus-buy policies of a major aerospace contractor. The firm made many products for the U.S. government.
The company had to choose between making each product or subcontracting it to another firm for production.
Economic theory suggests that internal production is more likely when the assets are specific and the uncertainties in
contracting are large.
Masten used two measures of asset specificity for each product. The first measured design (physical-asset)
specificity, whereas the second measured site specificity. He also measured the complexity of the product design, which
was intended to proxy for uncertainties in contracting. Consistent with the theory, he found that products which were
more design specific and quite complex were more likely to be produced internally. When the product was both design
specific and complex, there was a 92 percent probability of internal production. If the product was design specific but
not complex, the probability of internal production was 31 percent. The probability of internal production was only
2 percent when the product was neither design specific nor complex. For this particular company, site specificity was
unimportant.
In the years since Masten’s study, a large number of researchers have provided evidence from other industries that
support Masten’s initial findings and related predictions that derived from Oliver Williamson’s “Transaction-Cost
Theory.” A detailed review of these studies concludes: “The weight of the evidence is overwhelming. Indeed, virtually
all predictions from transaction-cost analysis appear to be borne out by the data.”
Source: S. Masten (1984), “The Organization of Production: Evidence from the Aerospace Industry,” Journal of Law & Economics 27, 403–417; and F. LaFontaine and M. Slade (2007), “Vertical Integration and Firm Boundaries: The Evidence,” Journal of Economic Literature 45(September), 631–687.
A C A D E M I C A P P L I C AT I O N S
18This section draws on Grossman and Hart (1986).
Chapter 19 Vertical Integration and Outsourcing 633
benefit other divisions (although they may have limited incentives to do so through stock ownership and profit-sharing plans). Thus they will invest little in learning about AutoCorp’s design plans if the benefits go primarily to AutoCorp. Yet Auto- Corp’s management, being at the top of the corporation, will be evaluated on overall corporate performance. They will have incentives to invest in all activities that ben- efit the overall corporation. Thus they will work to invest in lowering BodyWorks’ costs if it increases the overall value of the firm. In contrast, if BodyWorks owns Au- toCorp the reverse situation holds. BodyWorks’ management has incentives to invest in activities that increase total firm value, whereas AutoCorp’s management will focus primarily on divisional performance. Which ownership structure is best depends on whose investments are most important. Typically it is better for the party whose investments have the bigger impact on the value of the firm to be the owner. If both parties’ investments are important, it can be best to maintain separate ownership and use contracts. This idea is explored in more detail in the appendix.
Other Reasons
Unions are another factor that can affect the choice between vertical integration and contracting. For instance, some of the major airlines have threatened labor unions that they will outsource their kitchen operations to other companies to avoid paying union wages. The major automobile companies have made similar statements with respect to the manufacturing of component parts. Some firms are reluctant to integrate into a unionized activity because they fear that the move might motivate their employees to organize.
Controlling sensitive, proprietary information can affect decisions of outsourcing versus vertical integration. Along these lines, Prahalad and Hamel argue that it often is unwise for a company to outsource its “core competencies” (those capabilities which are fundamental to a firm’s performance and strategy). Rather, according to this argument, firms should keep core competencies within the firm to enhance their development and to prevent other firms from developing similar capabilities (see Chapter 8).19
The financial press often argues that obtaining inputs through contracts with other firms “frees companies to use scarce capital for other purposes.” This claim is questionable given access to well-developed capital markets. Having another firm produce a product does not reduce investment; it simply shifts the capital expenditures to another firm. Buyers still pay for this investment through the price of the product. The important question is whether more value is created by producing the product internally or externally. If internal production is more valuable, the firm can raise money in the capital market for financing the relevant assets: Capital is not “scarce” for good projects. If external production is more valuable, funds must be raised by the supplier.20
19C. Prahalad and G. Hamel (1990), “The Core Competence of the Corporation,” Harvard Business Review 68 (May–June), 79–91.
20One situation where this argument might make sense could involve an international business transaction
between a firm from an industrialized country and a firm from a developing economy. For example, Boeing
might offer to lease airplanes to a Chinese airline—thus bundling its product with a financing package—
because Boeing has more effective access to global capital markets than does its customer.
634 Part 4 Applications of Organizational Architecture
Some U.S. firms also claim that they outsource manufacturing to companies in China and other foreign countries because “that is where the sales are.” While this can explain why a firm would locate its manufacturing in a foreign country, it does not explain why the firm would choose to outsource the activity. For example, Japanese automobile companies manufacture cars in the United States in plants that they own. Presumably the choice between ownership and outsourcing in a foreign country depends on other factors, such as the political risk of expropriation of assets.
Continuum of Choice
Although we have discussed long-term contracting versus vertical integration as a choice between two policies, it is important to keep in mind that the outsourcing de- cision falls on a continuum. For example, sometimes it is desirable for a firm to maintain ownership of a firm-specific asset and contract with another firm to operate it. Apple does this with some of its outside suppliers. This ownership pattern reduces potential holdup problems because if there is a contract dispute, the owner can take the asset and simply contract with an alternative firm to provide the service (neither side faces large losses). This ownership pattern is most viable if the asset can be moved at low cost and the value of the asset is relatively insensitive to asset mainte- nance or abuse. Alternatively, the owner must be able to provide the service operator with sufficient incentives to maintain and not to abuse the asset.
A related example is companies choosing to contract with IBM for providing operating software and hardware but to maintain responsibility for applications
Vertical Integration to Avoid Contracting with Competitors Prior to 1975, virtually all community banks obtained products and services (such as loan participations and check
clearing) through correspondent relationships with large regional and/or money-center banks. During the last quarter of
the 20th century, some small community banks reduced their traditional reliance on correspondent banks for upstream
products and services by joining bankers’ banks—a form of business cooperative and a move from outsourcing to a
type of vertical integration.
Explanations for vertical integration have traditionally focused on firm-specific investment, market power, and
government regulation. However, formation of bankers’ banks is difficult to explain in terms of these standard vertical-
integration motives. Research suggests that bankers’ banks are a response to technological change and deregulation that
results in increased costs faced by community banks in dealing with correspondent banks as both suppliers and
potential competitors. For instance, loan participations require sharing proprietary information about major loan
customers, something a community bank would not want to provide to a potential competitor.
When United Banker’s Bank (UBB) formed in 1975 its founding community-based banks faced serious threats such
as new laws that made it easier for large system-wide competitors to invade their local markets, thereby competing for
their customers. The UBB founders believed they were doing business with the enemy. In fact, UBB’s founding vision
was to “Level the competitive playing field with systems banks by providing community banks with a full range of
innovative correspondent services secure in the knowledge that nobody would ever come after their customers.”
Source: J. Brickley, J. Linck and C. Smith (2012), “The Economic Determinants of Vertical Organization: Evidence from Bankers’
Banks.” Journal of Financial Economics 105(1), 113–130.
A C A D E M I C A P P L I C AT I O N S
Chapter 19 Vertical Integration and Outsourcing 635
software. Development of applications software is likely to be more specific to a given company than developing of operating software that can be used for many different applications and firms. IBM, therefore, has greater incentives to focus on developing operating software. The location of specific knowledge reinforces these incentives: A company knows more about its specific applications, and IBM knows more about general computing. The observed organizational arrangement reflects these incentive and information effects.
Contract Duration A major advantage of long-term contracts over short-term contracts is that they in- crease the incentives of the contracting parties to make firm-specific investments. For example, IBM would have limited incentives to invest in learning Manulife’s special computing demands if it anticipated only a short-term relationship between the two companies.21 On the other hand, it is costly to write and litigate long-term contracts in uncertain environments, where it is difficult to plan for potential changes in technology, input prices, product demands, and the like. Thus, firms might be expected to enter long-term contracts when the desired investment is relatively firm- specific and where the environment is relatively stable. Alternatively, if the firm faces a highly uncertain environment and large investments in firm-specific assets,
ANALYZING MANAGERIAL DECISIONS: BioChem Pricing Policy
BioChem has a patent on a chemical product, that
is, used as a key input in producing farm and home
agricultural fertilizer. Currently, BioChem pro-
duces the product and sells it to companies who
manufacture the final products for the farm and
home users. BioChem faces the following demand
curves from the farm and home market segments:
Farm: P � 300 � 10Q
Home: P � 100 � 5Q
BioChem can produce the product at a constant
marginal cost of $1.
1. Calculate the optimal prices that BioChem
would like to charge in each market segment
to maximize profits.
2. Discuss how vertical integration might be used
to accomplish this pricing policy. Be sure to
indicate the market into which BioChem
should vertically integrate (assume they can
integrate only into one). Explain why you
chose this market.
21Long-term contracts provide the greatest incentives when they have uncertain expiration dates (the parties
expect the contracts might be renewed). There are strong incentives to cheat in the last period when a
contract has a known ending date, since maintaining the reputation as a good partner has no benefit (ignoring
third-party effects). The parties, knowing that they will not cooperate in the last period, have incentives to
cheat in the next-to-last period. (There are no reputational concerns since they know that the other party will
not cooperate in the last period.) The incentives to cheat in the next-to-last period affect the incentives in the
previous period, and so on. In this case, the contract can unravel, so that the parties have the incentive to
cheat in the first period. L. Telser (1980), “A Theory of Self-Enforcing Agreements,” Journal of Business 53, 27–44.
636 Part 4 Applications of Organizational Architecture
vertical integration is more likely to be the preferred alternative. Finally, if the investment in firm-specific assets is relatively low or if the lives of the assets are relatively short, the firm can more easily enter into short-term contracts with suppli- ers or rely on spot market transactions.
Contracting with Distributors Although our examples have focused on supply contracts, the same analysis applies to distribution contracts. As assets become more specific, vertical integration be- comes more desirable. Yet a number of other interesting issues arise in distribution contracts. We now examine these issues.
Free-Rider Problems
Earlier in this chapter, we noted the incentives of independent distributors to free-ride on the reputation of a brand name and how these incentives can motivate suboptimal sales efforts—for example, insufficient expenditures on advertising and other inputs. One method of reducing this problem is vertical integration.22 The other method is to
Economic Determinants of Contact Duration Many contracts, including most commercial, labor, and real estate agreements, contain explicit expiration dates.
Typically, the terms of an agreement (e.g., the rent in a lease contract) are not renegotiated until the contract expires,
barring some event such as default. Major changes in contracts typically are renegotiated only when the agreements are
renewed.
Economic models suggest that recontracting costs, relationship-specific investment, and environmental uncertainty
are important determinants of contract duration. The potential benefits of longer-term contracts are lower recontracting
costs (since recontracting occurs less frequently) and reduced “hold-up” of relationship-specific investment. Thus
contract length is expected to increase with recontracting costs and specific investment. The potential costs of longer-
term contracts arise from rigidities that limit the parties’ abilities to respond to environmental changes (assuming that it
is more expensive to renegotiate an agreement prior to expiration). Since these costs are likely to increase with
environmental uncertainty, most models predict that contract length will decrease with uncertainty.
A study based on a large sample of franchise contracts provides evidence that supports these hypotheses. The
authors find that the term of the contract systematically increases with the franchisee’s physical and human capital
investments, measures of recontracting costs, and the franchisor’s experience in franchising (which presumably is
negatively related to uncertainty about optimal contract provisions). These results are consistent with the basic
argument that the optimal contract duration involves a trade-off between protecting the parties against potential hold-up
of relationship-specific investment and reducing the flexibility that the parties have to respond to environmental
changes.
Source: J. Brickley, S. Misra and L. Van Horn (2006), Contract Duration: “Evidence from Franchise Contracts,” Journal of Law and Economics 49 (April), 173–196.
A C A D E M I C A P P L I C AT I O N S
22H. Marvel (1982), “Exclusive Dealing,” Journal of Law & Economics 25, 1–25.
Chapter 19 Vertical Integration and Outsourcing 637
use contracts with specific provisions to control free-rider problems. Two contract terms that specifically address this concern are advertising provisions and exclusive territories.
Advertising Provisions Firms use several related methods to increase advertising at the local level. First, a company can charge its retail units an advertising fee and have the central company retain the responsibility for advertising. For instance, most franchise contracts require that, in addition to the base royalty payment, individual units pay a percent- age of sales to the central company to provide advertising. One potential problem with this approach is that the local unit, not the central company, might have the
M A N A G E R I A L A P P L I C AT I O N S
Outsourcing Gone Bad Not all outsourcing ventures work—some end in divorce. A dramatic example is the $4 billion deal between the U. S.
Navy and EDS to manage voice, video, networking training and desktops for 350,000 Navy and Marine Corp users.
One year later EDS wrote off close to $350 million due to its inability to come even close to fulfilling its obligations.
EDS had obtained the contract in 2003 after beating out competitors, such as IBM and Accenture. The reasons behind
the failure are complex. One of the major problems was that EDS, perhaps anxious to win the prize, did not realize
until it was too late that the Navy and Marine Corps had tens of thousands of legacy and customer applications for
which it was expected to either integrate or rip and replace. An EDS spokesman indicated that the company’s goal was
to get the number of legacy apps down to a “mere” 10,000–12,000. This example illustrates how lack of specific
knowledge about the other firm’s situation at the time of initial contract can lead to subsequent problems and divorce.
There are many other “horror stories” about firms that have outsourced functions unsuccessfully “offshore.” These
stories range from conflicts of interest (such as service providers getting kickbacks from landlords on the leased space)
to projects being torn apart by huge turnover rates. As one outsourcing consultant notes, “you end up with project
teams that are hugely inconsistent. You might have a good team in place, but a month later, three-quarters of the team
has transitioned.”
Even well thought out ventures have some probability of failure. However, these examples suggest that managers
on both sides of the contract should be careful to analyze costs, benefits, and risks before entering an outsourcing
venture.
Source: E. Schwartz (2008), “Painful Lessons from IT Outsourcing gone Bad,” InfoWorld (August 25).
M A N A G E R I A L A P P L I C AT I O N S
Conflicts over Advertising Provisions Meineke Discount Muffler Shops were initially ordered to pay $600 million to its franchisees by a federal district court
in North Carolina. Franchisees started noticing that the franchiser had been reducing advertising. Newspaper ads were
waning, and TV spots were appearing after midnight. It appeared that instead of the contractually specified 2 percent,
Meineke was pocketing $17 million, or 15 percent of the communal ad funds. The judge said the franchiser had a
fiduciary duty to ensure that the franchisees’ funds were properly managed. The case was subsequently reviewed by an
appeals court. Meineke owners almost settled the case for around $100 million before the appellate court’s decision
came through. Lucky for them, they did not. The appeals court ruled in their favor concluding that there was no legal
basis for imposing liability on the company and the case was dismissed.
Source: A. Lorenz (2009), GKN: The Making of Business, 1759–2009 (John Wiley and Sons: West Sussex).
638 Part 4 Applications of Organizational Architecture
specific knowledge relevant for effective local advertising. A second alternative that addresses this concern is for the central company to share in the local advertising costs; for example, it might pay half of any advertising expenditures. The decisions on local advertising are made by the local managers, but by reducing the effective cost of advertising, they encourage the local unit managers to advertise more exten- sively. A third alternative is to require distributors to contribute to regional advertis- ing funds. The distributors have the primary decision rights to decide how to spend the monies in the funds.
Exclusive Territories One of the most common methods to control free-riding is to grant individual distributors exclusive rights to operate in a given market area. For example, an AutoCorp dealership might have a contract that prevents the company from opening another dealership within 30 miles. By giving distributors exclusive rights for specific market areas, there are fewer incentives to free-ride, since the distributors internalize more of the benefits from their sales efforts and fewer benefits go to other units not owned by the given distributor. Exclusive territories also can create extra profits for local distributors. These profits can provide additional incentives not to free-ride: If the manufacturer catches the distributor free-riding and terminates the contract, future profits are lost.23
Double Markups
Granting distributors market power within specific areas reduces free-rider problems, but it can create another problem—double markups. Since both the manufacturer and the distributor face downward-sloping demand curves, each has the incentive to mark up the product’s price above marginal cost. Unchecked, this results in the customer’s facing two markups rather than one. Hence, both the quantity of the product de- manded and the combined profits for the manufacturer and distributor are less than they would be if this incentive were controlled. The following is a numerical example illustrating this problem, as well as the contract terms that might be used to control it.
Example Suppose that AutoCorp faces the following demand for its Rhino automobiles in the Medford, Oregon, market area:
P � 55,000 � 100Q (19.3)
AutoCorp can produce Rhinos at a constant marginal cost of $5,000. To simplify the computations, assume that there are no fixed costs in producing or selling cars. To max- imize profits, AutoCorp must select the quantity and price where marginal revenue equals marginal cost. As depicted in Figure 19.6, the optimal quantity and price are Q* � 250 and P* � $30,000. The firm’s profits are $6.25 million.
Now suppose that AutoCorp sells its vehicles through SUVmart, an independent distributor that has the exclusive right to sell Rhinos in the Medford market area. Under the contract, AutoCorp sets the wholesale price, while SUVmart selects the
23B. Klein and K. Murphy (1988), “Vertical Restraints as Contract Enforcement Mechanisms,” Journal of Law & Economics 31, 265–297; and J. Brickley (1999), “Incentive Conflicts and Contractual Restraints: Evidence from Franchising,” Journal of Law and Economics 42, 745–774.
Chapter 19 Vertical Integration and Outsourcing 639
quantity to purchase and the retail price. For simplicity, suppose that the only mar- ginal cost facing SUVmart for Rhinos is the price charged by AutoCorp. (There are no variable distribution costs.) The owners of SUVmart care only about their own profits, and the managers of AutoCorp care only about AutoCorp’s profits. The prob- lem facing AutoCorp is to choose the wholesale price, Pw, that maximizes its profits.
MR D MC
$
55,000
30,000
Q* � 250 Q
Quantity of automobiles
5,000
P ri ce
a n d c
o st
p e r
a u
to m
o b ile
(i n d
o lla
rs )
Pw* �
Figure 19.6 Optimal Output in an Example of the Double Markup Problem
AutoCorp can produce automobiles at a constant marginal cost of $5,000. To maximize profits, AutoCorp must select the quantity and price where marginal revenue equals marginal cost. The optimal quantity and price are Q* � 250 and P*w � $30,000. Firm profits are $6.25 million (assuming no fixed costs).
Company Ownership versus Franchising We have discussed how a central company can reduce the incentives of an independent distributor to free-ride on the
brand name through contracts with terms that motivate increased sales efforts. When the free-rider problem is severe, it
can be less expensive simply to own the distribution units centrally. Managers of a company-owned unit have fewer
incentives than an independent distributor to free-ride on the reputation, since they do not get to keep the profits from
the unit—the reduction in costs (e.g., from decreased advertising) flow through to the central company, not the
managers.
Most franchise companies do not franchise all their retail outlets. The typical company franchises about 80 percent
of the units and owns the other 20 percent. Our argument suggests that central companies are most likely to own the
units that receive a significant amount of business from customers who are unlikely to make repeat purchases at the
particular units (the incentives to free-ride in this case are large). On average, fast-food restaurants are more likely to
serve transient customers than auto-service companies. (Customers tend to use the same unit repeatedly for oil changes
and tune-ups.) Consistent with the theory, the typical restaurant franchise company owns about 30 percent of its units,
and the typical auto service franchise company owns about 13 percent of its units.
Source: J. Brickley and F. Dark (1987), “The Choice of Organizational Form: The Case of Franchising,” Journal of Financial Economics 18, 401; and R. Blair and F. Lafontaine (2014), The Economics of Franchising (Amazon Kindle Edition).
A C A D E M I C A P P L I C AT I O N S
640 Part 4 Applications of Organizational Architecture
SUVmart
MR D
MC
$$
42,500
30,000
275Q* � 125 550
Q
AutoCorp
MR
Quantity Quantity
MC D Q
5,000
275Q* � 125
P ri ce
p e r
u n it
(i n d
o lla
rs )
Pr* �
55,00055,000
30,000 Pw* �
Figure 19.7 Example of Double Markups
AutoCorp sets the wholesale price for its automobiles, while SUVmart selects the quantity to purchase and the retail price. SUVmart maximizes profits by setting the wholesale price equal to its marginal revenue. Thus, SUVmart’s marginal revenue curve is AutoCorp’s demand curve. AutoCorp maximizes profit by setting its marginal cost of $5,000 equal to its marginal revenue. AutoCorp selects a wholesale price P*w of $30,000, a $25,000 markup above its marginal cost, whereas SUVmart selects a retail price P*r of $42,500, a $12,500 markup above its marginal cost. SUVmart sells 125 cars at this price. The combined profits are $4.688 million. The two companies could earn combined profits of $6.25 million if they cooperate and sell 250 automobiles to consumers at a price of $30,000.
To solve this problem, AutoCorp’s management would like to know the quantity that SUVmart would purchase at each feasible wholesale price. AutoCorp can infer this demand curve by analyzing the problem from the perspective of SUVmart. SUVmart faces the retail demand curve for autos given in Equation (19.3). SUVmart maximizes its profits by setting its marginal revenue, implied by this retail demand curve, equal to Pw, its marginal cost. Thus, SUVmart’s marginal revenue curve is the effective demand curve AutoCorp faces. (At any wholesale price, SUVmart buys the quantity indicated by its marginal revenue curve.) As depicted in Figure 19.6, this curve is
Pw � 55,000 � 200Q (19.4)
Given SUVmart’s demand for Rhinos, what wholesale price will AutoCorp choose? AutoCorp maximizes its profits by setting its marginal revenue equal to its marginal cost of $5,000. Since AutoCorp faces a demand curve of Pw � 55,000 � 200Q, its marginal revenue is MR � 55,000 � 400Q. AutoCorp’s profits are maximized by selecting a wholesale price of Pw* � $30,000. At this price, SUVmart will buy 125 Rhinos and set a retail price of $42,500. AutoCorp will have profits of $3.125 mil- lion, and SUVmart will have profits of $1.563 million, for combined profits of $4.688 million.
This outcome, which is depicted in Figure 19.7, is inefficient. AutoCorp and SUVmart fail to maximize their joint profits. Both parties could be made better off
Chapter 19 Vertical Integration and Outsourcing 641
by coordinating their prices and volume choices—we already have shown that they could earn up to $6.25 million (vs. $4.688 million). In addition, with the double markups, consumers pay $42,500 for 125 Rhinos rather than $30,000 for 250.
This problem does not automatically disappear if AutoCorp merges with SUVmart. We saw in Chapter 17 that exactly the same problem can arise within firms, when products are sold between two profit centers using internal transfer prices. As we discussed, the transfer-pricing problem can be reduced by appropriate organizational design. Our current focus is to look at how this problem might be re- duced between two independent firms through specific contractual terms.
Two-Part Pricing SUVmart will purchase 250 Rhinos if AutoCorp sets a wholesale price of $5,000. This quantity maximizes the joint profits of the two firms and results in a retail price of $30,000. The entire profits, however, go to SUVmart, since AutoCorp is selling the automobiles at cost. One solution is for AutoCorp to charge SUVmart an up-front franchise fee—thereby extracting its share of the profits through this fee—and then to sell automobiles to SUVmart at $5,000 each. Since SUVmart’s purchasing decision is based on marginal cost, not total cost, it still will purchase 250 automobiles and set a retail price of $30,000. If AutoCorp charges SUVmart an up-front fee of $3.125 million for the exclusive rights to the Medford market area, the combined profits of $6.25 million are split evenly between the two com- panies. Once the fee is collected, AutoCorp might try to increase the wholesale price of the automobiles to increase its profits. Thus, for such a solution to work, AutoCorp must be able to commit credibly to sell automobiles to SUVmart at mar- ginal cost.
Quotas An alternative method for maximizing the combined profits is for the two compa- nies to agree on a minimum purchase requirement. SUVmart could agree to pur- chase at least 250 automobiles at a prespecified wholesale price (above $5,000). Given the details in this example, SUVmart will purchase exactly 250 automo- biles and sell them at $30,000 to retail customers. The level of the prespecified wholesale price determines the split of the profits between the two companies. A wholesale price of $17,500 splits the profits evenly (each company nets $12,500). AutoCorp must be able to commit credibly to the wholesale price, and SUVmart must purchase the agreed-upon quota.
Regulatory Issues
Some regulators and scholars are suspicious of contract terms such as exclusive ter- ritories that potentially limit competition. Nonetheless, most nonprice contract terms are not per se illegal (always illegal) under federal antitrust law. They are judged on a rule of reason, where the court attempts to consider the benefits of the terms (such as increased sales efforts) against potential anticompetitive effects. In some states, automobile dealers and franchisees have successfully lobbied their legislators to limit the control that central companies impose—for example, in setting quotas and terminating contracts. In addition, federal law restricts central companies from
642 Part 4 Applications of Organizational Architecture
directly controlling the pricing by distributors at the retail level. A detailed treatment of these regulatory issues is beyond the scope of this book.24 Suffice it to say that it usually is important for firms to engage expert legal counsel to advise in designing supply and distribution contracts.
Trends in Outsourcing Major companies make much greater use of outsourcing today than they did in the 1980s. At least four factors have contributed to this change. First, new flexible produc- tion technologies allow suppliers to adapt more easily to customer demands. Thus, in some cases, assets are becoming less firm-specific—a technological innovation that favors contracting over vertical integration. Second, improvements in information and communications technology make it easier to identify potential partners and to communicate with them after an agreement is reached. Electronic data interchange al- lows firms to connect their computers to each other. These computers can automatically
ANALYZING MANAGERIAL DECISIONS: Oil Industry Distribution Systems
Major oil companies use a dual distribution system
for gasoline. Some stations are direct-serve, where the oil company delivers gasoline to the station.
Other stations are served by distributors. Distribu-
tors are independent businesspeople who buy gas
from the oil company and sell it to stations. Dis-
tributors also own their own stations. The land,
tanks, and equipment at the direct-serve stations are
owned by the oil company and leased to the dealer
(franchisee). The dealer buys gas from the oil com-
pany and pays rent for the land. The dealer keeps
the profits from the station over the life of the
lease. (Some direct-serve stations are centrally
owned by the oil company. At these locations, the
oil company hires a manager to operate the sta-
tion.) At direct-serve stations, the oil company is
responsible for environmental cleanup, local adver-
tising, monitoring of the station (to protect the
brand name), and so on. The distributors are re-
sponsible for these activities at the stations they
serve. Typically the oil company sells gas to dis-
tributors at about 7 cents less per gallon than it sells
gas to dealers at its direct-serve stations.
1. Oil companies do not allow dealers (fran-
chisees) to buy gas from distributors. Dealers
must buy gas from the central oil company.
Dealers often complain that this is unfair. The
practice has been the subject of antitrust
lawsuits. Oil company executives argue that
this policy is important because it limits free- riding on the part of the distributors. Explain the executives’ arguments in more detail.
2. Suppose the courts ruled that the oil companies
must allow the dealers to buy gas from distrib-
utors. What effects do you think such a ruling
would have on the operational policies of the
oil companies?
3. Some direct-serve gasoline stations provide
repair services, and others concentrate almost
exclusively on self-service gasoline sales.
Which type of station is more likely owned by
the central oil company and which type is more
likely to be franchised? Explain.
4. Typically the stations served (and owned) by
distributors are located in rural areas, whereas
the direct-serve stations are located in urban
areas. Give two economic reasons to explain
why you might expect such a pattern.
24For a more detailed treatment of these issues, see R. Posner (1976), Antitrust Law (University of Chicago Press: Chicago); and D. Carlton and J. Perloff (1990), Modern Industrial Organization (HarperCollins: New York).
Chapter 19 Vertical Integration and Outsourcing 643
order inventory directly from a supplier with little human intervention. Third, there has been a dramatic increase in worldwide competition. This competition has placed greater pressure on firms to reduce costs and increase efficiency. Some scholars argue that many American firms were “flush with cash” in the 1960s and 1970s and were more likely to waste this cash through such actions as engaging in too much in- tegration.25 Some recent outsourcing decisions thus might be corrections for poor in- vestment decisions of the past. Fourth, during the early 1990s, there was a worldwide recession, which caused excess capacity in many industries. In this environment, firms often could obtain large discounts from external vendors. (This effect should be more cyclical than permanent.)
Many recent outsourcing decisions do not move firms from internal production to the other end of the spectrum (spot market transactions). Rather, the movement has been to an intermediate arrangement—long-term contracting. Many firms also have moved away from acquiring inputs in the spot market. To improve quality and lower unit costs, firms such as General Motors and Xerox have cut their number of suppli- ers dramatically and correspondingly have increased the number of long-term partnerships with independent firms. Thus, those trends can be viewed as movements from each end of the spectrum toward the middle.
M A N A G E R I A L A P P L I C AT I O N S
The Politics of International Outsourcing In 2001, Daimler Chrysler decided to overhaul its computing systems by inviting IBM, EDS, and other U.S. giants to
bid on the job. It awarded the task to the Indian firm Infosys Technologies, Ltd. Infosys’s cost was 25 percent lower.
Since then, other Indian and Chinese software companies have been undercutting Western adversaries by as much as
70 percent. In 2000, 125 of the top 500 U.S. firms outsourced software projects to Indian firms. By 2003, 285 of these
firms have Indian software and technology suppliers, including Boeing, Cisco, and Lehman Brothers. To compete with
the lower labor costs in Asia, India, and Eastern Europe, large U.S. technology firms like IBM, Accenture, Dell, and
Hewlett-Packard have either acquired Indian companies or are opening Indian offices. In 2003, IBM and Accenture
each hired between 4,000 and 5,000 employees in India.
And it is not just software jobs that are moving overseas. Call centers, architectural services, medical transcription,
and other service jobs are moving offshore. Goldman Sachs estimated that between 2001 and 2003, 200,000 service
jobs had been outsourced overseas to U.S. affiliates. Worried about its image of stealing U.S. jobs and the possibility of
U.S. government legislation that might stem the outsourcing of U.S. jobs to India, the Indian government engaged
several large Washington-based lobbying firms to design an “educational” campaign extolling the benefits of closer
U.S. ties with India. One lobbying firm was paid $600,000 in 2003 to advise India and to lobby Congress to prevent
antioutsourcing legislation.
International outsourcing became a major issue in the 2004 U.S. presidential campaign. Presidential candidate
Senator John Kerry charged President Bush with wanting “to export more of our jobs overseas.” Gregory Mankiw,
President Bush’s chief economic advisor, claimed that sending U.S. service jobs abroad “is probably a plus for the
economy in the long run” because foreign workers can do the jobs more cheaply, thereby reducing costs for U.S.
consumers and companies.
Source: M. Kripalani and S. Hamm (2004), “Scrambling to Stem India’s Onslaught,” BusinessWeek (January 26), 81; M. Schroeder (2003), “India Aims to Calm U.S. Outsourcing Fears,” The Wall Street Journal (November 13); and B. Davis (2004), “Some Democratic Economists Echo Mankiw on Outsourcing,” The Wall Street Journal (February 12), A4.
25M. Jensen (1986), “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76, 323–329.
644 Part 4 Applications of Organizational Architecture
Technological changes, such as just-in-time production methods, electronic data interchanges, and total quality manufacturing, require close links between manufac- turers, suppliers, and distributors. Rather than inspecting parts and materials from numerous suppliers on delivery, a few suppliers are selected and their production processes are certified as meeting high-quality standards. Thus, although the various activities in the manufacturing/distribution process are conducted by different firms, it is important that these firms remain closely linked. In such cases, these factors make spot market transactions undesirable.
Recently, however, some companies have moved some activities that were out- sourced internationally back into the United States.26 For example, well-known com- panies such as Google, General Electric, Caterpillar, and Ford Motor Company have brought some of their production and other functions back to America with some of it being done “in-house.” In 2013, Apple announced it would start making a line of
ANALYZING MANAGERIAL DECISIONS: AutoCorp
AutoCorp produces automobiles. It has asked the
Amalgamated Fabric Company to consider a pro-
posal to become a supplier of automobile seats.
Under the proposal, Amalgamated Fabric would
construct a $20 million plant near one of Auto-
Corp’s production facilities. AutoCorp would pur-
chase 100,000 car seats per year at a price of $280
per seat for 15 years—the useful life of the plant.
(The actual proposal contains an adjustment for in-
flation. Ignore this complication in the analysis.)
Amalgamated Fabric’s financial analysts have
examined the proposal. It appears to be a prof-
itable opportunity. The amortized cost of the plant
is $2.6 million per year (at a discount rate of
10 percent). The annual costs are $25.4 million
per year. Therefore, the average total cost is $280
per seat—ATC � ($25.4 million � $2.6 million)/ 100,000 � $280. The financial analysts have ex- amined AutoCorp’s financial outlook. Although it
has not been highly profitable in all years, there is
essentially no probability of bankruptcy over the
next 15 years. Since the proposed price covers the
cost, the financial analysts think that the proposal
should be accepted. (It breaks even with a fair rate
of return on invested capital of 10 percent.)
You have been asked to analyze the contract
proposal. You have seen the financial analysis and
think the cost estimates are reasonable. You are
aware that, due to its location, the proposed plant
has no alternative use other than supplying seats to
AutoCorp. The salvage value of the plant, in the
event of liquidation, is $2 million.
1. One concern you have is that AutoCorp might
try to lower the effective purchase price of the
seats after the plant is built (by reneging on the
contract or demanding higher-quality seats for
the same price). Once the plant is built, how
much can the purchase price fall before
Amalgamated Fabric liquidates the plant?
2. What factors would you consider to decide
whether opportunistic behavior by AutoCorp
is a likely possibility?
3. Does AutoCorp have to worry about any
opportunistic actions by Amalgamated
Fabric?
4. What factors might make it difficult to write a
contract that would limit opportunistic behav-
ior by both companies?
5. What are the costs and benefits of AutoCorp
vertically integrating and supplying its own
automobile seats?
6. What are the costs and benefits of having
AutoCorp construct the plant and letting
Amalgamated Fabric operate it on a
contractual basis?
26See Special Report: Outsourcing and offshoring (2013) “Here, there and everywhere,” The Economist (January 19).
Chapter 19 Vertical Integration and Outsourcing 645
its Mac computers in America. The most important reason for this reversal is that global labor “arbitrage” is being eliminated through competition in international labor markets. (“Law of One Price” at work). Wages in China and India have been increasing at rates between 10 and 20 percent per year over the past decade; while wages in America and Europe have been stagnate. Continued low wages in Vietnam, Eastern Europe, Indonesia, and the Philippines have attracted some new outsourcing ventures, but they do not have China’s scale, efficiency or supply chains. Also the cost of shipping heavy goods halfway around the world by sea has increased signif- icantly making foreign production of goods ultimately sold in the United States less attractive. U.S. companies also have become increasingly concerned about the threat of losing intellectual property and with the risk that remote supply chains will be disrupted by war or other violence.
Summary When a firm participates in more than one successive stage of the production or dis- tribution of a product or service, it is said to be vertically integrated. Firms change their degree of integration over time. An organization that begins to produce its own inputs is engaging in backward or upstream integration, whereas an organization that begins to market its own goods or to conduct additional finishing work is engaging in forward or downstream integration. The term outsourcing frequently is used to de- scribe a movement away from vertical integration—moving an activity outside the firm that formerly was done within the firm. The term outsourcing also is used to de- scribe an ongoing arrangement where a firm obtains a part or service from an exter- nal firm. It is useful to think of the outsourcing decision as a choice along a contin- uum of possibilities, ranging from spot market transactions to vertical integration with an array of long-term contracts in-between.
Well-functioning markets provide powerful incentives for efficient production and low prices; thus, firms acquire many goods and services through market trans- actions. Economists have identified at least three primary reasons why a firm might want to engage in nonmarket procurement: Contracting costs, market power, and taxes/regulation. Four factors can make the contracting costs of nonmarket procure- ment lower than the costs of market exchange. These factors include firm-specific assets, costs of measuring quality, externalities, and coordination problems.
Firm-specific assets are assets that are substantially more valuable in their current use than in their next best alternative use. Investment in firm-specific assets can cause enormous problems between suppliers and buyers and is a primary reason for non- market transactions. Once the investment in firm-specific assets is made, there is a sunk cost—the supplier has incentives to continue the relationship as long as the vari- able costs are covered—even if total costs are not. This incentive subjects the supplier to a potential holdup problem. The buyer also can be held up by the supplier. One way of reducing these problems is to integrate vertically. The other method is to negotiate a detailed contract that spells out the rights and responsibilities of each party.
Due to contracting costs, most contracts are incomplete: Many contingencies are unspecified and subject to future negotiation. The prospect of future negotiations can motivate suboptimal investment in both capital and effort. Parties to the contract re- alize that part of the gains from their investments are likely to go to other parties: They are not protected by a complete contract.
The owner has the right to determine the residual use of an asset—any use that does not conflict with prior contract, custom, or law. Residual rights give an individual increased ability to capture the gains from an investment and thus can
646 Part 4 Applications of Organizational Architecture
provide investment incentives. Vertical integration and long-term contracts differ in their assignment of ownership rights. Vertical integration keeps the ownership rights for the relevant assets within one firm, whereas long-term contracting apportions them between firms. The choice between vertical integration and long-term contracts depends, at least in part, on which ownership structure creates more productive in- vestment decisions.
A primary prediction of the economics literature is that as an asset becomes more firm-specific, the firm is more likely to choose vertical integration over long-term contracting. The analysis suggests that firms will enter long-term contracts when the desired investment is relatively firm-specific and where the environment is relatively stable and predictable (in stable environments, the range of possible circumstances to cover is more limited and negotiating more complete contracts is less costly). Conversely, if the firm faces a more uncertain environment and large investments in firm-specific assets, vertical integration is more likely to be the preferred alternative. Finally, if the investment in firm-specific assets is relatively low (the assets are un- specialized) or the lives of the assets relatively short, the firm can either enter into short-term contracts with suppliers or rely on spot market transactions.
Independent distributors can have incentives to free-ride on a brand name. One method to reduce this problem is vertical integration. Another method is to use con- tracts with specific provisions that control free-rider problems. Two types of contract terms that specifically address this concern are advertising provisions and exclusive territories. Exclusive territories help internalize free-rider problems, but they create another problem—double markups. This problem (which is analogous to the trans- fer-pricing problem examined in Chapter 17) can be reduced through two-part pric- ing or quotas.
At least four factors have contributed to the observed trends in outsourcing that have occurred over the last few decades increased worldwide competition, the development of less firm-specific production technologies, improvements in information and com- munication technologies, and excess capacity from a worldwide recession. The trend, however, is not from vertical integration to spot market transactions. It is a movement from both ends of the spectrum toward an intermediate solution of some form of long- term contracting. Technological changes, such as just-in-time production methods, electronic data interchanges, and total quality management, require closer links be- tween manufacturers, suppliers, and distributors. These changes reduce the desirability of spot market transactions in many cases. More recently, increases in the wage rates in China and India, along with increased transportation costs and concerns about interna- tional violence, have motivated some large U.S. companies to move some internally outsourced activities back to the United States.
D. Carlton and J. Perloff (1999), Modern Industrial Organization, 3rd edition (HarperCollins: New York), Chapter 16.
O. Hart (1995), Firms, Contracts, and Financial Structure (Oxford Press: Oxford).
B. Holmstrom and J. Robert (1998). “The Boundaries of the Firm Revisited,” Journal of Economic Perspectives 12(4): 73–94.
B. Klein, R. Crawford, and A. Alchian (1978), “Vertical Integration, Appropriable Rents, and the
Competitive Contracting Process,” Journal of Law & Economics 24, 297–326.
F. LaFontaine and M. Slade (2007), “Vertical Integration and Firm Boundaries: The Evidence,”
Journal of Economic Literature 45, 629–685.
Suggested Readings
Chapter 19 Vertical Integration and Outsourcing 647
P. Rubin (1990), Managing Business Transactions (Free Press: New York).
M. Whinston (2003), “On the Transaction Cost Determinants of Vertical Integration,” Journal of Law, Economics, and Organization 19(1): 1–23
O. Williamson (1985), The Economic Institutions of Capitalism (Free Press: New York).
19–1. Assume that Ford Motor Company can produce an automobile at a constant marginal cost of $4,000. The demand for the car in the Rochester area is P � 60,000 � 100Q. a. What is the profit-maximizing price and quantity? What are the profits from this
activity?
b. Now suppose that Ford sells its cars through an independent distributor, Rochester Autos, which has the exclusive right to sell new Fords in the Rochester area. Under the
contract, Ford sets the wholesale price, and Rochester Motors selects the quantity to
purchase and the retail price. The only cost facing Rochester Motors is the wholesale
price of the car. Ford and Rochester Autos both strive to maximize their own profits.
What are (1) the wholesale price, (2) the retail price, (3) the quantity sold, and (4) the
combined profits of Ford and Rochester Autos?
c. Describe how Ford might use a two-part pricing scheme to eliminate this successive monopoly problem with Rochester Motors. (No calculations are necessary.)
19–2. In explaining a decision to purchase an independent R&D laboratory, an executive of the acquiring company said,
We felt we had to purchase the company to give us patent rights on any important discoveries. Without these rights, we would have few incentives to invest in the marketing and distribution systems that are necessary to support the discoveries.
Evaluate this logic.
Solutions to Self-Evaluation Problems 19–1. Ford Motor Distribution
a. MR � MC 60,000 � 200Q � 4,000
Q* � 280
P * � 60,000 � 100 � 280 � $32,000
Profits � (32,000 � 4,000) � 280 � $7,840,000
b. Ford’s demand curve is Rochester Auto’s marginal revenue curve. Thus it will set:
60,000 � 400Q � 4,000
It will sell 140 autos to Rochester Autos at a wholesale price of $32,000. The retail
price will be $46,000. Combined profits will be $5,880,000 ($3,920,000 � $1,960,000). c. Ford could charge an up-front licensing fee to Rochester Autos to transfer profits from
Rochester Autos to Ford. Ford would then sell the cars to Rochester Autos at marginal
cost ($4,000). Ford would sell 280 automobiles to customers at a retail price of $32,000.
Joint profits would be maximized.
19–2. R&D Lab Purchase
This quote only considers half of the contracting problem. Ownership by the acquiring com-
pany might increase the investment incentives of that company; however, it can decrease the
investment incentives of the managers at the R&D laboratory (because they are less likely to
capture the gains from the investment). The optimal ownership pattern depends, in part, on
whose investment incentives are more important.
Self-Evaluation Problems
648 Part 4 Applications of Organizational Architecture
19–1. Discuss the pros and cons of the policy described in the following quote from Fortune27:
According to the new thinking, any kind of work to which a company can’t bring a spe- cial set of skills should be spun off, outsourced or eliminated. Thus AT&T, GE, IBM, and Shell Oil are in the process of spinning off legal, public relations, billing, payroll, and other services. What’s left, whether it’s a $100 million corporation or a $100 bil- lion corporation, is the ideal size. . . . For example, if marketing is a competitive ad- vantage in an industry, then it should build up its marketing muscle and employ outside suppliers and service firms to do everything else.
19–2. The Black Diamond Company mines coal. It would like to build a processing plant right next to its major mine. The location of this mine is relatively remote and is not near other
coal mines. Tax considerations, as well as government regulations, dictate that the process-
ing plant be owned and operated by some independent company (other than Black Dia-
mond). Your company, the Greg Norman Coal Company, is considering building and oper-
ating the plant for Black Diamond on a contract basis. Your job is to negotiate the contract
with Black Diamond. Discuss the terms that you will try to get Black Diamond to agree to
in the contract. Explain why these terms are important to you.
19–3. Evaluate the following quote:
The major advantage to outsourcing is that it reduces a company’s capital costs, freeing the company to use scarce capital for other purposes.
19–4. In explaining the recent acquisition of a supplier, an executive made the following argu- ment: “We purchased the supplier so that we could keep the profit rather than pay it to
some other firm.” Evaluate this argument.
19–5. Cable television companies lay cables to individual households in the communities they serve to carry the television signal. How specific is this investment? What kind of arrange-
ments would you expect the cable companies to make with local communities about the
pricing and taxation of cable services? Explain.
19–6. The Hidden Fence Company sells invisible electric fences to contain dogs within yards. For a half-acre lot, the cost is $2,000 for the system and installation. The market for invisi-
ble dog fencing is competitive: Several companies sell similar products at about the same
price. In each case, the dog wears a battery-powered collar. The collar give the dog a shock
if it gets near the boundary of the property. Hidden Fence uses a specially designed collar
that uses batteries made specifically for Hidden Fence by the Battery-O-Vac Company.
The batteries last for three months and cost $25 apiece. Hidden Fence has a patent on
these batteries, and there are no alternative sources of supply. Other fence companies pro-
duce products that use generic batteries. Currently, the battery costs of these other systems
are the same as for Hidden Fence.
a. Suppose that you purchase the system from Hidden Fence. After you purchase the sys- tem, how much will Hidden Fence be able to raise the price of its batteries before you
discontinue use of the system and buy a different system from another company?
(Suppose that you do want to maintain an invisible fence.) For this question, assume a
10 percent annual discount rate, no inflation, and an infinite life for the invisible fence,
yourself, and the patent for the batteries.
b. As the manager of Hidden Fence Company, what might you do to convince a worried prospective customer that opportunistic behavior with respect to battery prices is not a
likely occurrence?
19–7. Advanced Interconnect Manufacturing Inc. (AIM) is an independent company. It was pre- viously owned by one of its major customers before being purchased by five managers
(with the help of outside investors). AIM assembles wire harnesses for use in machines
such as copiers and x-ray machines. The vice president of the company claims that the
Review Questions
27B. Dumaine and J. Labate (1992), “Is Big Still Good?” Fortune (April 20), 50.
Chapter 19 Vertical Integration and Outsourcing 649
company is more efficient because “as an independent company, AIM doesn’t have to
share any of its major customer’s corporate overhead.” As he notes, the company’s CEO
doesn’t get paid by us.”
a. Evaluate the vice president’s explanation for the increased efficiency of AIM since the ownership was changed.
b. Give an alternative explanation for the increased efficiency.
19–8. Jimmy’s Stereo Company manufactures stereo equipment. Its business strategy is to provide retail customers with high-quality equipment, along with good service and warranty protec-
tion. It currently distributes its products through licensed dealers who have exclusive territo-
ries. Discuss (1) why Jimmy’s might offer its distributors exclusive territories, (2) the poten-
tial problems that this policy might create in terms of retail pricing, and (3) potential
policies that Jimmy’s might use to address this pricing problem.
19–9. BQT Manufacturing produces electric lamps. To produce these lamps, BQT must either make or acquire bases for the lamps. Currently, the company outsources the production of the bases
for their lamps to the ACE Lamp Company. BQT maintains ownership of the machinery, that
is, used to produce the bases. ACE uses BQT’s machines at plants owned by ACE.
a. Why do you think BQT is subcontracting the production of the bases? b. Why do you think BQT maintains ownership of the production equipment? c. What problems might be caused by BQT’s maintaining ownership of the production
equipment?
d. What might BQT do to reduce the magnitude of these problems?
19–10. Most of the McDonald’s restaurants in the Rochester area are owned by one individual. Discuss why this ownership pattern makes economic sense.
19–11. You are at a cocktail party, where you meet the CEO of a pharmaceutical company who has been thinking recently about her overseas distributors who have exclusive sales territories.
She can’t quite figure out what is troubling her, but she is dissatisfied with these distribu-
tors. You describe the “double markup” problem. The CEO’s eyes light up. “You are exactly
right,” she says. “The distributors are setting prices for our product that are too high.” A
year passes. You meet the CEO at another party. She heads straight for you and says,
You were wrong. There was no double markup problem. After our talk a year ago, I terminated the contracts with all our overseas distributors. I sent our own people over- seas to set up in-house distributors. To motivate the region managers I tied a big part of their compensation to the profitability of their regions. I was sure I would see a big change, but overseas prices are just about the same as they were when we used exclu- sive distributors. I guess prices weren’t that bad with the distributors.
Do you think the CEO’s conclusions are correct? Why or why not?
19–12. The Boswell Medical Center is the only hospital in a rural community. It requires signifi- cant janitorial services to clean its buildings and equipment. It also requires a relatively
large lab for conducting tests of various types (e.g., MRIs, blood tests, and ultrasound
tests). Do you think that Boswell is more likely to outsource its janitorial services or lab
work? Explain.
19–13. The Hanson Clinic is a well-regarded medical center located in a semirural area in the Midwest. One of its specialty areas is treating rare forms of cancer. To support this activity
Hanson wants to construct a new lab. The lab will require very specialized equipment, a
specially designed building, and a skilled staff. The estimated cost of the equipment and
building is $50 million.
The clinic is considering three possible organizational arrangements. The first is verti-
cal integration. The second is outsourcing (where another company constructs the build-
ing, purchases the equipment, and provides contractual services to the clinic). The third is
for the clinic to purchase the equipment and building, and lease them to an independent
operator (who would provide contractual services to the clinic).
Discuss the pluses and minuses of each of the three alternative structures. What fac-
tors do you think are most important in making this choice?
650 Part 4 Applications of Organizational Architecture
19–14. Koji Incorporated produces high-end cameras. Its typical camera comes with an array of options. The company has a good brand name.
a. Koji distributes its cameras through independent dealers who are given exclusive distribution rights for their respective market areas. Discuss why it might make eco-
nomic sense for Koji to grant its distributors exclusive territories.
b. Since Koji adopted this distribution system, it has experienced a double markup prob- lem. What is a double markup problem?
c. Discuss how Koji might use a two-part pricing scheme to reduce the double markup problem. (Be sure to specify what the two-part pricing scheme would entail.)
d. Describe one other method that Koji might use to address the double markup problem.
This appendix provides a more detailed example of how ownership rights can affect investment incentives (in this case, investments in effort). Through this example, some of the important trade-offs between vertical integration and long-term con- tracts become more evident.
Basic Problem The AGT Company manufactures computer modems. The company is owned by Valentina Vezzali. The Custom Circuit Company makes circuit boards for AGT. AGT is Custom’s only customer, and Custom is AGT’s sole supplier of circuit boards. The boards are tailor-made for AGT and cannot be used by other manufacturers (the boards are firm-specific). Custom Circuit is owned by Phillipe Daurelle.
AGT might want to make future design changes in its circuit boards. For simplicity, suppose that the future benefit of a design change to AGT can take only two values, 20 or 40, whereas the costs to Custom of making the change can be ei- ther 10 or 30. The likelihood of a high benefit and a low cost is influenced by both Tina’s and Phil’s efforts. Let x equal the probability that the benefit is 40. Tina can affect this probability through her efforts—in fact, we assume that Tina’s efforts completely determine x. For instance, by working with customers, she can determine the best design change to make. She also can spend time marketing the revised product. These types of activities increase the probability that the benefits from the design change will be large. However, the personal cost to Tina of exerting effort is 10x 2. As an example, if Tina exerts enough effort so that x is 0.5, she incurs a personal cost of 10(0.5)2 � 2.5. Similarly, Phil’s actions completely determine y, the probability that the cost equals 10, at a personal cost of 10y 2. For instance, Phil can exert effort on developing more cost-effective ways to manufacture the new circuit boards.
Neither Tina’s nor Phil’s effort choices are observable by the other party. Tina does not know y and Phil does not know x. Although both Tina and Phil ultimately can observe the realized costs and benefits of the design change, they cannot be ver- ified by a third party. Thus, neither effort, costs, nor benefits are contractible; it is not possible to provide either party with incentives through a contract tied to realized costs or benefits of the design change.
Appendix: Ownership Rights and Investment Incentives28
28This appendix uses elementary probability theory and calculus. This section draws on B. Holmstrom and
J. Tirole (1989), “Theory of the Firm,” in R. Schmalensee (Ed.), Handbook of Industrial Organization, Vol. 1 (North Holland: Amsterdam), 69–72.
Chapter 19 Vertical Integration and Outsourcing 651
Ideal Effort Choices Value is created by a design change whenever the benefits of the change exceed the costs. The only time that the design change does not create value is when the bene- fits are 20 and the costs are 30. Both Tina and Phil are risk-neutral. It is in their joint interests to choose effort levels that maximize expected surplus. By maximizing the size of the pie, there is more value to share and both parties can be made better off. Ideally, the joint expected surplus SJ for the two companies is
SJ � (40 � 10)xy � (40 � 30)x (1 � y) � (20 � 10)(1 � x)y � 10x 2 � 10y 2 (19.5)
� 30xy � 10x (1 � y) � 10(1 � x)y � 10x 2 � 10y 2
� 10xy � 10x � 10y � 10x 2 � 10y 2
This equation is maximized by choosing effort levels of y � x � 1.29 The joint ex- pected surplus net of effort costs is 10.
Actual Effort Choices under the Contract The specific contract between AGT and Custom requires that a design change be approved by both companies. Since Tina and Phil have equal bargaining power, they anticipate splitting the surplus, that is, available from any future design change. For instance, if the benefits are 40 and the costs are 10, the total surplus is 30. A price for the circuit boards of 25 splits the gains: Tina gains 40 � 25 � 15 and Phil gains 25 � 10 � 15.
Tina and Phil choose their effort levels privately (the effort choices cannot be ob- served by the other person). Each person chooses an effort level that maximizes his or her own surplus, given the anticipated effort choice of the other party. As we shall see, both parties choose effort levels below the values that maximize the joint sur- plus. The low effort choices result from the standard free-rider problem. Tina and Phil bear the total costs of their personal efforts but receive only half the benefits.
Consider Tina’s problem. Her expected surplus ST is
ST � .5(40 � 10)x � .5(40 � 30)x (1 � ) � .5(20 � 10)(1 � x) � 10x 2 (19.6)
� 15x � 5x (1 � ) � 5(1 � x) � 10x 2
� 5x � 5x � 5 � 10x 2
where is the effort level that she expects Phil to exert.30 Taking the partial deriva- tive with respect to x and setting it equal to zero,
�ST��x � 5 � 5 � 20x � 0 (19.7)
Phil’s first-order condition is, similarly,
�SP��y � 5 � 5 � 20y � 0 (19.8)
In a Nash equilibrium, both Phil’s and Tina’s first-order condition will be met and the effort choices will be x � 1�3 and y � 1�3 (at these values, neither party has the
x
y
y
y
yyy
yyy
29Technical note: The first three terms in Equation (19.5) are the three possible outcomes of positive surplus
multiplied by the probability of the outcome. The last two terms are the effort costs. Note: If the benefits are
20 and the costs are 30, the design change is not implemented; the term (0)(1 � x)(1 � y) drops out of Equation (19.5). The first-order conditions are 10 � 10y � 20x � 0 and 10 � 10x � 20y � 0. The solution is x � y � 1.
30She bears the full cost of her effort, 10x 2, but receives only half the benefits.
652 Part 4 Applications of Organizational Architecture
incentive to alter his or her choice). The total surplus, net of effort costs, is 5.6 [sub- stitute y � x � 1�3 into Equation (19.5)].
Vertical Integration One way to change effort incentives is for the two firms to integrate vertically, either by having AGT buy Custom or by having Custom buy AGT. Consider the case where Tina purchases Custom from Phil and hires him as an employee to manage AGT’s “Custom Circuit Division.” Ownership gives Tina the decision rights to implement the design change without Phil’s approval (she has the residual use rights). Since Phil has no bargaining power, all the surplus goes to Tina. Phil has no incentives to exert effort on increasing the likelihood of a low production cost: He bears all the costs for his personal effort and reaps none of the benefits. (Recall that we have ruled out incentive contracts tied to realized costs or benefits of design changes.) Given y � 0, the cost of implementing the design change is 30 for certain. Tina’s benefits from investing are
(40 � 30)x � 10x2 (19.9)
Tina will choose x � 1�2. The total surplus, net of investment costs, is 2.5.31 The case where Custom buys AGT is symmetrical, Phil invests y � 1�2, and total net surplus is 2.5.32 Clearly, vertical integration is not superior to a long-term contract.
Optimal Organizational Choice When Tina and Phil negotiate the sale of either company, they can share the expected surplus in any manner by negotiating the appropriate purchase price. They have incen- tives to choose the ownership structure that maximizes the expected net surplus. Given the numbers in this example, they will choose not to combine the two companies. Sep- arate ownership creates more value than integration.
This example illustrates that ownership structure can matter because it affects in- vestment incentives (in this case, investments in effort). Ownership gives individu- als increased power to capture the fruits of their efforts (see Chapter 10) and thus can provide important incentives. In this example, separate ownership is better than integration because both parties’ investments are important. It is better to provide moderate incentives to both Phil and Tina than strong incentives to only one party. It is easy to envision cases where integration will be the preferred alternative. For instance, suppose that Tina can exert effort to affect the benefits of the design change, but Phil has little control over the costs. Here, it would make sense for AGT to own Custom. This ownership structure provides strong incentives for Tina to exert effort and weak incentives for Phil. These incentives are optimal, since only Tina’s effort matters. Conversely, it makes sense for Custom to own AGT when Phil’s effort is substantially more important than Tina’s.
In this example, we have ruled out the possibility that effort can be motivated by incentive compensation (making payments based on the realized costs and benefits). We made this extreme assumption specifically to isolate the important incentive effects of ownership. More generally, owners can motivate internal
31Tina’s first-order condition is 10 � 20x � 0. The solution is x � 1�2. The total surplus is found by substituting x � 1�2 and y � 0 into Equation (19.6).
32This symmetry is a result of the cost and benefit functions in our example. More generally, it can matter who
buys whom.
Chapter 19 Vertical Integration and Outsourcing 653
employees through incentive compensation. For instance, if AGT purchased Cus- tom, Tina might be able to pay Phil in a manner that would encourage him to exert some effort to reduce costs. Similarly, in the separate ownership case, AGT and Custom might be able to include incentive clauses in the contract that would en- courage investment (for instance, Custom might receive extra revenue from AGT if it can produce the new design at low cost). As we discussed in Chapters 15 through 17, incentive schemes and performance evaluation are not costless activ- ities. In a more detailed analysis, AGT and Custom would have to compare the value that could be created using an optimal supply contract without integration to the value that could be created using optimal incentive compensation contracts under integration. The basic point of our analysis continues to hold—ownership structure matters because it can affect investment incentives.
ANALYZING MANAGERIAL DECISIONS: Insurance Industry Distribution Systems
Insurance companies contract with independent
agents to sell policies and provide ongoing services
to customers. Ongoing client services tend to be
more important in auto insurance companies than
life insurance companies. In some insurance com-
panies, the agents “own” the client list. If they stop
representing the firm, they can take the clients with
them to a new company. In other cases, the insur-
ance company owns the list. The agent is not al-
lowed to take clients to another company. (There is
a formal contract with this provision.) Do you think
life insurance companies or auto insurance compa-
nies are more likely to employ independent agents
who own their client lists? Explain.
chapter
20 C H A P T E R O U T L I N E
Leadership
Vision Setting
Motivation
Decision Making within Firms
Incentive Problems and Organizational Politics
Understanding Attitudes toward Change
Changing Organizational Architecture
Proposal Design
Maintaining Flexibility
Commitment
Distributional Consequences
Marketing a Proposal
Careful Analysis and Groundwork
Relying on Reputation
Emphasizing a Crisis
Organizational Power
Sources of Power
Tying the Proposal to Another Initiative
Coalitions and Logrolling
Is Organizational Power Bad?
The Use of Symbols
Summary
Appendix: Strategic Value of Commitment and Crisis
I n 1982, David Kearns was appointed CEO of Xerox Corporation, the leading producer of copy machines in the world.1 At that time, the com- pany faced serious problems. Between 1976 and 1982, Xerox’s share of installations of new copiers in the United States dropped from about 80
percent to 13 percent. Japanese companies—Canon, Minolta, Ricoh, and Sharp—had become major players in this market. These companies were selling copiers at prices that at times were lower than Xerox’s costs for pro- ducing competing machines.
A major reason for Xerox’s decline in market share was poor product quality. As Kearns put it,
Our customer cancellations were rapidly on the rise, our response to the problem was to try to outrun them by pushing hard to get enough new orders to offset the customers we had lost. Customers were fed up with our copiers breaking down and our service response.
Kearns reasoned that if something was not done, “Xerox was destined to have a fire sale and close down by 1990. [The] only hope for survival was to urgently commit the company to vastly improving the quality of its products and services.”
According to Kearns, most Xerox employees understood neither the extraordinary gravity of the problem nor the fundamental importance of improving product quality. He realized that even as CEO, he could not
Leadership: Motivating Change within Organizations
L E A R N I N G O B J E C T I V E S
1. Define leadership and list two important characteristics of good leadership. 2. Discuss the obstacles to having business plans adopted and implemented. 3. Describe how changing the firm’s organizational architecture can help motivate
changes within the firm.
4. Discuss the trade-offs associated with maintaining flexibility in the proposal stage versus the implementation stage of a business plan.
5. Explain how a manager can market a business plan within the firm. 6. Define organizational power; give specific examples 7. Explain how symbols can be used to shape employee expectations of appropriate
behavior.
1Details of this example are from D. Kearns and D. Nadler (1992), Prophets in the Dark (Harper Business Press: New York).
20-2 Part 4 Applications of Organizational Architecture
implement his vision of increasing product quality simply by ordering thousands of employees to focus more on quality. First, employees did not necessarily pos- sess all the skills required to produce quality products. Second, unless employees were convinced that it was in their individual interests to focus more on quality, it would be difficult to motivate them to alter their behavior. Certainly, Kearns did not have the time to monitor each employee to see if his vision was being imple- mented. Third, Kearns faced a difficult balancing act; he feared that painting too dismal a picture would induce some key people to leave the company.
In response to these concerns, Kearns initiated a strategy to shift corporate direc- tion. He realized that many Xerox employees would oppose the kind of dramatic change he envisioned. They might fear for their jobs, worry about changes in job as- signments, or be concerned about having to relocate. Kearns began by convincing a select group of key executives that additional focus on quality was essential. These individuals not only helped refine this quality vision, but also helped convince other employees of the potential benefits of this change in focus. Employees throughout the company received substantial training in quality techniques. The importance of quality was emphasized at every opportunity—media releases, management speeches, signs on bulletin boards, and so forth. In addition, they stressed the poten- tial crisis posed by the Japanese successes.
Yet after much training and promotion, the desired change in culture simply was not occurring. It was then that Kearns realized that to affect employee behavior, senior management had to do more than just exhort, cajole, and plead—the performance- evaluation and incentive systems also had to change. As Kearns says,
Unless people get rewarded and punished for how they behave, no one will really believe that this is anything more than lip service. A widespread problem [with imple- menting change] that was singled out was that people said we were still promoting and rewarding employees who weren’t true believers and users of the quality process. This was creating noise in the system and sending mixed signals. It had to stop.
Kearns thereafter initiated changes in the criteria for promotions and compensation decisions, placing major emphasis on customer satisfaction and quality. Eventually, the culture at Xerox did change. In 1989, Xerox won the Malcolm Baldrige National Quality Award.
This example suggests that effective leadership involves a great deal more than just developing an appropriate vision for the company. It is critical to motivate people to implement that vision. Changes in a firm’s organizational architecture— the assignment of decision rights, reward system, and performance-evaluation system—can play an important role in motivating material organizational change. Marketing the concept to other employees also is important.
The framework developed in this book provides insights for more effective leader- ship—both structuring an appropriate architecture as well as implementing new ideas. Rudolph Giuliani stresses that an important responsibility of a leader is to impose a structure suitable to an organization’s purpose.2 This was our focus in Chapters 11–17. In this chapter, we concentrate on how effective leaders implement new ideas, which might include a new organizational architecture. The insights in this chapter thus are useful not only for executives at the top of the organization, but also for employees who have the opportunity to assume various leadership roles and
2R. Giuliani with K. Kurson (2002), Leadership (Hyperion: New York).
Chapter 20 Leadership: Motivating Change within Organizations 20-3
want to have their ideas implemented. Our leadership discussion presents an important example of how this book’s framework can be used to provide a structured analysis of this popular (though ill-understood) topic.
We begin by discussing the concept of leadership in more detail. Next, we discuss decision making within firms and present a framework for understanding attitudes toward change within organizations. We use this framework to analyze various strategies for motivating employees to endorse proposals for change. These strategies include changing the organizational architecture, analyzing the strategic design of the proposal, and marketing the proposal. In the final sections of the chap- ter, we provide an analysis of the sources of individual power within an organiza- tion and a brief discussion of the use of symbols—role modeling, formal creeds, stories, and legends—in leadership. In the appendix, we present a simple example of the strategic value of commitment and crisis.
Leadership Webster’s defines leadership as “leading others along a way, guiding.” This defini- tion suggests that there are at least two important characteristics of good leadership. First, the leader must help the organization choose the right path—vision, goal, or plan. Second, the leader must help motivate people to follow it. Much of the popular literature on leadership stresses these two characteristics. To quote John Gardner, “The two tasks at the heart of the popular notion of leadership are goal setting and motivating.”3 Since these tasks are performed by people throughout the organization, leadership is in no sense the exclusive domain of senior executives. Throughout the firm, many employees assume important leadership roles.
Vision Setting
By vision, we simply mean a course of action for the firm.4 Sometimes leaders de- vise a corporate vision by themselves. According to Kearns, he was among the first people to envision Xerox as a quality-based organization. But senior executives nor- mally do not have all the relevant specific knowledge and cannot be expected to con- ceive important visions entirely by themselves. In many cases, a vision emanates from a lower-level employee or even from a person outside the firm—for example, a consultant. Often, the information for formulating a vision has to be assembled by combining the knowledge of numerous individuals. Firms typically involve many employees in developing mission statements. One aspect of effective leadership in- volves structuring organizational architecture in a manner that motivates employees with the relevant specific knowledge to initiate value-enhancing proposals—to take part in vision setting. It is this view that has prompted much of the current literature on the role of managers in empowering employees to “unleash their untapped creativity.”
3J. Gardner (1990), On Leadership (Free Press: New York), 11. 4The management literature differentiates among the terms vision, strategies, and plans. Visions represent goals and objectives, whereas strategies and plans relate to how to achieve them. For our purpose, this
differentiation is unimportant. We are interested in any type of proposal that implies change for the
organization. We use the term vision as a catchall for these proposals.
20-4 Part 4 Applications of Organizational Architecture
Motivation
Although an appropriate vision is important, it cannot increase a firm’s value un- less it is implemented. Thus, the task of motivation is at least as important as the task of goal setting. It is often better to implement a pretty good plan than to identify yet fail to implement the perfect plan. Literature on leadership often emphasizes motivation skills:5
• Leadership is the process of persuasion or example by which an individual in- duces a group to pursue objectives held by the leader or his or her followers.
• I define leadership as leaders inducing followers to act for certain goals that represent the values and the motivations—the wants and needs, the aspirations and expectations—of both leaders and followers.
• The one who knows the right thing but cannot achieve it fails because he is in- effectual. The great leader needs . . . the capacity to achieve.
Some people argue that leaders motivate people to follow visions through per- sonal charisma, style, and inspiration. Under this view, the bonds between leader and follower are more emotional than rational. Certainly, strong emotional ties some- times motivate individuals to follow a leader’s call to action. Leaders often cited as charismatic include Mahatma Gandhi, John F. Kennedy, and Martin Luther King, Jr. Charisma undoubtedly explains much of the behavior of individuals in particular settings (e.g., in certain religious cults). Business managers might glean some valuable lessons from studying the styles of inspirational leaders, but for most indi- viduals, charisma is difficult to learn.
Yet the economic framework suggests that other attributes of effective leadership can be learned. Economics stresses that people make choices that are in their own self- interest. They are more concerned about their own welfare (which can include
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Vision Setting: Lessons from the Enterprise In my experience, the best-run companies have a basic philosophy that the people in the company know and understand.
Sometimes this philosophy is formalized in a mission statement. Here is the best mission statement I have ever heard:
These are the voyages of the Starship Enterprise. Her five-year mission: To explore strange new worlds, to seek out new life and new civilizations, to boldly go where no one has gone before.
Crew members of the Starship Enterprise know exactly what they are supposed to do. Suppose you are the dumbest person on the ship. And suppose you encountered a strange new world. What should you do? Explore it, perhaps. There
is even an emotion telling you how you should go about exploring it: Boldly.
What if your company encounters a strange new opportunity? Without a basic philosophy, even a business’s smartest
employees have to improvise when they meet a new or challenging situation. We could do worse than rewriting the Star
Trek mission statement for whatever venture we are on. Make the language exact, the goal specific, and even your worst
employee will make you proud.
Source: D. Marinaccio (1994), All I Really Need to Know I Learned from Watching Star Trek (Crown Publishers: New York).
5Emphases in the following quotes are ours. The quotes are taken, respectively, from Gardner (1990), 1;
J. Burns (1978), Leadership (Harper & Row: New York), 19; and R. Nixon (1982), Leaders (Warner Books: New York), 5.
Chapter 20 Leadership: Motivating Change within Organizations 20-5
concerns about family, community, and so on) than they are about the welfare of the owners of the company. In this sense, the problem of motivating employees to follow a proposed direction or course of action is just the standard incentive problem. Below, we discuss techniques that managers can use to address this problem.
Decision Making within Firms
Incentive Problems and Organizational Politics
Academic discussions often treat decision making as a purely intellectual exercise: Relevant alternatives are identified, analysis is conducted, and the best alternative is chosen. (Consider the standard treatment of capital budgeting in finance courses.) Implementation problems often are ignored. In this context, good leadership is equivalent to initiating good proposals and conducting careful analysis. Within most firms, the decision process is much more complicated than this simple characteriza- tion reflects. Although developing good proposals and conducting careful analysis are important, they are far from sufficient for effective leadership. Just because a proposal would increase firm value is no guarantee that it will be either ratified or implemented.6 Due to incentive problems, decision making within firms often resembles decision making in political settings such as government. There are self- interested people involved in group decision making.7 To quote Jeffrey Pfeffer,
Organizations, particularly large ones, are like governments in that they are fundamentally political entities. To understand them, one needs to understand organizational politics, just as to understand governments, one needs to understand government politics.8
Understanding Attitudes toward Change
To provide richer insights into the decision-making process within firms, consider the problem facing Christian Seidler, a general manager at the BCT Corporation. Like David Kearns at Xerox, Chris is convinced that his division must adopt a quality-improvement program to remain competitive. He needs support from Claudia Kobatzki, the CEO, for ratification of the program and support from employees in his division for implementation. Chris does not think that the quality program will be a success unless he has the full support of his department managers. He also depends on these managers for advice, because they have important specific knowledge about
6Recall that four important steps in the decision-making process are initiation, ratification, implementation,
and monitoring (see Chapter 12). 7As we have discussed in previous chapters, if there were no transaction costs, individuals in the group would
agree unanimously on a course of action to maximize value. By maximizing the size of the pie, all of the
individuals are made better off: Every individual’s piece of the pie can be enlarged by the appropriate side
payments. Transaction costs limit the likelihood of this outcome within large organizations. For example,
suppose that laying off a group of workers will create value but that the labor union has the power to veto the
layoffs. With no transaction costs, the owners and labor will agree on the layoffs. The owners share the
increase in value by making appropriate severance payments to the workers. Both parties are better off.
Bargaining costs often prevent this result from occurring (asymmetric information is a particular problem).
In this case, the parties do not have a shared common interest in maximizing value. Similar to other political
settings, conflicts arise as all parties try to increase their own share of the pie. 8J. Pfeffer (1992), Managing with Power (Harvard Business School: Boston), 8.
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whether his proposal is a good idea. If the managers were to oppose his proposal strongly, Chris would consider withdrawing it. We focus on Lynn Vestergaard, a de- partment manager who reports to Chris.
Consider the proposal from Lynn’s perspective. She is risk-averse and interested in maximizing her own utility, which increases with the expected payoffs that she re- ceives from BCT, PL, and falls with the standard deviation of these payoffs, sL (see Chapter 2):
(20.1)
Expected payoffs include both monetary and nonmonetary compensation from the company. For instance, Lynn gains utility from her salary, supervising a large num- ber of employees, administering a large budget, and working in California. She will not support Chris’s proposal simply because it increases the firm’s value. It must in- crease her personal utility.
Figure 20.1 displays Lynn’s expected payoff and standard deviation under the status quo (assuming the company does not adopt the proposed program). Also displayed is the indifference curve, which contains all combinations of expected payoffs and standard deviations that provide Lynn with the same utility as the status
UL � f (P �
L, s � L)
Lynn’s current indifference curve
Status quo
Standard deviation (in dollars) E
xp e ct
e d p
a yo
ff (
in d
o lla
rs )
Favor proposal
Oppose proposal
P
s
Increasing expected utility
Figure 20.1 Framework for Understanding Attitudes toward Change
In this example, Lynn Vestergaard is a department manager at the BCT Corporation. Lynn is risk- averse. Her utility increases with her expected payoffs from the company and falls with the standard deviation of these payoffs. This figure displays her indifference curve associated with the status quo (assuming the company does not change its direction). Lynn will support proposals for change in the favor proposal region of the figure and be against proposals in the oppose proposal region.
Henry Kissinger on Decision Making Former Secretary of State Henry Kissinger offers the following observation about decision making:
Before I served as a consultant to Kennedy, I had believed, like most academics, that the process of decision making was largely intellectual and [that] all one had to do was to walk into the President’s office and convince him of the correctness of one’s view. This perspective I soon realized is as dangerously immature as it is widely held.
Source: H. Kissinger (1979), The White House Years (Little, Brown: Boston), 39.
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Chapter 20 Leadership: Motivating Change within Organizations 20-7
quo. (Recall that northwest movements in the graph are utility-increasing.) For Lynn to favor Chris’s proposal over the status quo, she must view the proposal as placing her in the region of the graph labeled “favor proposal.”
Lynn will oppose the proposal if it reduces her utility. For instance, if she thinks that the proposal will increase the likelihood that she will be laid off, she is likely to oppose the change. Now Lynn is unlikely to come right out and say that, because she fears for her job, she does not like the proposal. She is more likely to question his un- derlying analysis—even if she thinks it is right. She might waste time developing spurious evidence to convince people that the proposed program is unworkable. She might try to block the program by failing to do her part during implementation. If many employees in the firm undertake similar actions, the proposal will fail.
Chris cannot observe Lynn’s personal preferences. But he can analyze how the proposal is likely to affect her and make an educated guess of how she will react. One important factor to consider is the existing organizational architecture. What deci- sion rights does she have currently and how will she be affected by implementation of the proposal? How is she rewarded? If Lynn is paid a bonus based on divisional sales and the proposal is likely to reduce those sales, it is reasonable for Chris to anticipate that Lynn will oppose the proposal.
Suppose that Chris forecasts that Lynn will oppose his proposal. He might gain her support by employing one of three general tactics. First, he could change organizational architecture so that it is in Lynn’s interest to support the proposal. Second, he could change the proposal so that she is more likely to support it. Third, he might be able to market the proposal to Lynn by convincing her that actually it is in her self-interest to support the proposal. We discuss each of these general tactics below.
Changing Organizational Architecture Chris can make two general changes in his division’s architecture that would help him gain support for his proposal. First, he can identify individuals who are likely to support the proposal and give them increased decision rights, and correspondingly he can reduce the decision rights of individuals who are likely to oppose the
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Mismanaging Organizational Politics at Xerox Good analysis is not enough to motivate the implementation of new ideas in an organization. Often, a concerted effort
to gain the support of other employees is necessary. Xerox’s Palo Alto Research Center (PARC) invented the first
personal computer, the first graphics-oriented monitor, one of the first handheld computer mouses, the first word
processing program for nonexpert users, the first local area communications network, the first object-oriented
programming language, and the first laser printer. Xerox failed to capitalize commercially on any of this inventive
technology. One reason was that PARC was physically removed from the rest of Xerox and apparently did not
understand the importance of motivating other units in the firm (such as marketing) to support its technological visions.
Employees at PARC were characterized as being arrogant and suffering from a “we/they attitude toward the rest of
Xerox.” In the words of Jeffrey Pfeffer,
By not appreciating the interdependence involved in a new product launch and the skills required to manage that interdependence, PARC researchers lost out on their ambition to change the world of computing, and Xerox missed some important economic opportunities.
Source: J. Pfeffer (1992), Managing with Power (Harvard Business School: Boston), 38–39.
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proposal. Second, he can change the performance-evaluation and reward systems so that it is in the self-interest of more employees to support the new program. Kearns implemented both types of changes in architecture at Xerox.
To illustrate the effect of changes in the performance-evaluation and reward sys- tems, suppose that Lynn currently is paid a salary plus a bonus, based on sales by her department. Denote Lynn’s expected payoff and standard deviation, given this com- pensation plan without implementing Chris’s proposal, as the status quo (SQ). The indifference curve associated with SQ is depicted in Figure 20.2 (labeled “original indifference curve”). His proposal makes Lynn worse off relative to the status quo: The expected payoff is lower and the standard deviation is higher. Lynn will try to convince Chris that his proposal is a bad idea and should it be adopted is unlikely to exert great effort in implementing it. Now suppose that before suggesting the pro- posal, Chris changes the performance-evaluation and reward systems. Lynn now will be evaluated on product quality. If the quality in her department is poor, she has an increased likelihood of job loss as well as a lower expected bonus. This change in the reward system produces a new status quo (SQ�). Without adopting a quality pro- gram, chances are that Lynn’s quality would suffer and she might be fired. This change in architecture places her on a lower indifference curve (labeled “after changes in architecture”). Now when Chris proposes his quality program, he re- ceives Lynn’s support. She will want to attend quality workshops, provide instruc- tion to her employees in quality techniques, and participate in the program in other ways.9 She wants to take actions to improve quality in her department because now, participation makes her better off.
Original indifference curve for status quo (SQ)
SQ
SQʹ
Standard deviation (in dollars)
E xp
e ct
e d p
a yo
ff (
in d
o lla
rs )
Indifference curve for status quo (SQʹ) after changes in the architecture
Chris’s proposal
s
P Increasing expected utility
Figure 20.2 Changing the Architecture to Gain Support for a Proposal
In this example, Lynn Vestergaard will not support Chris Seidler’s proposal, given her current compensation plan. The status quo provides her with higher utility. Chris changes the architecture so that the status quo is worse—if Lynn does not improve quality, she is likely to be fired. Now, when Chris introduces the proposal, Lynn will support it and will do her part during the implementation phase.
9In this illustration, the change in the reward system affects Lynn’s assessment of the status quo. Chris’s changes in the reward system also might affect Lynn’s expected payoffs and risk under the proposed change.
The basic point continues to hold: Chris can influence Lynn’s attitude about the proposal by making changes
in the architecture.
Chapter 20 Leadership: Motivating Change within Organizations 20-9
Obtaining the approval of the CEO for the program and the support of department managers will not ensure that Chris’s proposal will be implemented successfully. There are potential incentive problems with other employees within the division (e.g., production workers). He can anticipate some of these problems by carefully analyz- ing these employees’ incentives. For instance, will these employees fear for their jobs, face fewer promotion opportunities, or have less challenging task assignments? Through this analysis, he can identify the employees who are most likely to resist im- plementation. Chris can make changes in the architecture to reduce the anticipated problems. He can make sure that certain groups of employees are monitored closely in the implementation phase (recall from Chapter 12 that monitoring is the fourth step in the decision-making process). He also might make additional changes in the performance-evaluation and reward systems. For example, he could reward employ- ees—perhaps, through promotions—for successfully implementing the quality concept. Or he might promise employees that they would not lose their jobs due to quality improvements. Such a promise would increase support for these programs.
As CEO, David Kearns, wanted to make dramatic changes in the culture at Xerox. To motivate employees to support these changes, he altered the firm’s performance- evaluation and reward systems. But most employees must exercise leadership within the existing architecture: They have only limited authority to make changes in either the performance-evaluation or reward systems. Even CEOs often choose to work within the existing organizational architecture, since changing the architecture can be expensive. (Remember, frequent changes in the evaluation and reward systems can discourage employees from making long-run investments and undercut incen- tives to develop relationships with teammates—see Chapter 11 and Web Chapter 23, available via Create or McGraw-Hill Connect®.) The following discussion suggests methods that managers can use to get their proposals implemented within the exist- ing organizational architecture. These techniques also can be used in conjunction with changes in the architecture.
Proposal Design Managers can analyze the incentives of key decision makers and design proposals that are more likely to be supported. We discuss three issues relating to proposal design: Flexibility, commitment, and distributional consequences.
Maintaining Flexibility
Holding the expected payoffs of a proposal constant, employees are more likely to support a new proposal if it entails lower risk. One way to convince people that the risk of a proposal is low is to design the proposal so that it can be modified easily once it is under way. A manager might suggest starting with a limited pilot program, involving only one region or a single product. If this pilot is successful, the program can be expanded. If not, it can be discontinued at low cost. A small-scale test does not commit the firm to adopt the program throughout the company: It provides an option to do so. Experiments of this type commit only limited resources while pro- viding more precise estimates of the costs and benefits of proposed actions. And this information is available both to senior executives who must approve an expanded program as well as to the employees in other areas of the firm where the program might be implemented subsequently.
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Commitment
Maintaining flexibility has benefits but also can impose costs. If employees think that senior management is not committed to the change, they have less reason to take the change seriously. In addition, employees who are against the change have increased incentives to take actions to convince senior management that the change is a poor idea. David Kearns made it quite clear that he was committed to the quality program at Xerox and that employees should take the change seriously. In the appendix, we present a more detailed example of the strategic value of commitment.
Distributional Consequences
Most proposals for change have distributional consequences—some employees gain and others lose. For instance, a plan to reduce the power of middle managers will harm middle managers but benefit certain line employees. Managers can de- sign proposals so that the distributional effects promote support among key decision makers. Returning to our example, Figure 20.3 considers the case of Lynn and an- other department manager, Robert Lewis. Both Rob and Lynn have the same utility function. They also view the status quo exactly the same (so they are on the same initial indifference curve). Chris’s proposal benefits Rob substantially but harms Lynn slightly. Chris can obtain support from both Rob and Lynn by modifying the original proposal so that Rob is less well off and Lynn is slightly better off. For in- stance, some of the employees who would have reported to Rob under the initial proposal might be reassigned to report to Lynn in the revised proposal. If Lynn val- ues supervising a larger number of employees, she is more likely to support the revised proposal.
Standard deviation (in dollars)
E xp
e ct
e d
p a
yo ff (
in d
o lla
rs )
Rob’s view of Chris’s proposal
Lynn’s view of Chris’s proposal
Status quo for both Lynn and Rob
P
s
Increasing expected utility
Figure 20.3 Analyzing the Distributional Consequences of a Proposal
In this example, Chris Seidler’s initial design of a proposal would be strongly supported by Rob Lewis and only mildly opposed by Lynn Vestergaard (both have the same initial indifference curve under the status quo). Chris can obtain both managers’ support by redesigning the proposal. For instance, Chris might reassign some employees who would have reported to Rob under the original proposal to Lynn. Assuming that both Rob and Lynn gain utility from supervising larger departments, Lynn gains and Rob loses utility. Chris’s objective is to make changes until both Lynn and Rob view the proposal as being better than the status quo.
Chapter 20 Leadership: Motivating Change within Organizations 20-11
Marketing a Proposal Employees’ attitudes toward a proposed change depend on their assessment of the ex- pected payoffs and risk under the new proposal, relative to the status quo. The spon- sor of the proposal often will have information that can affect this assessment. The sponsor might be able to convince an employee to support the proposal by conveying this information credibly to the employee.
Careful Analysis and Groundwork
Chris can anticipate initial opposition to his quality proposal because people are risk- averse. Individuals who are confronted with a new idea are likely to be unsure of the personal consequences of the action relative to the status quo—thus, they are likely to oppose it. Chris correspondingly should take time to explain his analysis to key em- ployees and to convince them that his analysis is correct. He might meet with these employees to discuss the proposal and answer questions. He might give speeches on the topic, write an article for the company paper, and so on. By carefully communi- cating the reasons he supports the plan—by lowering the costs for others to analyze the consequences—uncertainty is reduced. Correspondingly, there is increased sup- port for the proposal: More people view the proposal as being in the “favor proposal” region of Figure 20.1.
As a general rule, it is unwise to introduce important proposals at meetings and then request on-the-spot decisions. Without laying the appropriate groundwork, such proposals are likely to be tabled for further study or simply rejected. Since people are risk-averse, they tend to favor the status quo until they are convinced otherwise.
Relying on Reputation
People have reasons to listen to a person with an established reputation for offering sound proposals. First, past success is an indicator of analytical and organizational
Leverage and Commitment Firms obtain financing through combinations of equity and debt. Common stock is the most frequently used source of
equity capital for large firms. Dividend payments to holders of common stock are discretionary. The board of directors
can reduce dividend payments without placing the firm in bankruptcy. Payments to debt holders must be made in a
timely fashion to avoid bankruptcy. During the 1980s, many firms increased their amount of debt substantially through
activities such as selling bonds and repurchasing common stock.
High leverage can serve as a commitment that management intends to make changes in the firm to increase cash
flows to meet the higher debt payments (e.g., through cutting costs), since failure to increase cash flows can result in
bankruptcy. Managers have their “feet to the fire,” since they do not want to lose their jobs. Managers in firms financed
primarily by equity can be under less pressure to make changes to increase cash flows, since they have more flexibility
to decrease cash payouts to security holders. There are many determinants of the optimal amount of debt in a firm’s
capital structure. This discussion suggests that one determinant can be the desire of senior managers to commit to
employees and outside stakeholders that they will take actions to increase or maintain high cash flows.
Source: M. Jensen (1986), “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review 76, 323–329.
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skills and thus the likelihood of future success. Second, a successful person has strong incentives to conduct a careful analysis to avoid damaging that established reputation. If other employees are confident that a manager usually makes good de- cisions, they will attach less risk to that manager’s proposals and hence are more likely to support them. A manager with an established reputation can garner support for a proposal by asserting forcefully that it is beneficial. It is important for managers not to misuse their reputations by arguing passionately for marginal proposals. A manager’s reputation is diminished whenever proposals turn out to be unsuccessful.
Steve Jobs, CEO of Apple Computer, has been dubbed one of America’s 25 Best Leaders by USNews.com. He has had a tempestuous career—founding Apple and
Some Tips on Being a Leader Many of our most memorable leaders have emerged during wars or crises: Winston Churchill, Abraham Lincoln, and,
more recently, Rudy Giuliani and George W. Bush. People want to be led out of a “devotion born of distress” as
sociologist Max Weber observed. People want leaders to be a repository of people’s fears. A few simple tips can help
make you a more effective leader, especially in times of crises.
Stand up and be seen. Followers are more reassured if the leader is visible and seen as taking charge of the situation. Be brutally optimistic. Showing fear will make team members pessimistic. Tell people the bad news straight, but
remind them that eventually they will succeed. Remember Churchill’s famous statement of “blood, toil, tears, and
sweat” in the near term, but England would prevail “however long and hard the road may be.”
Stick to the facts. Do not exaggerate successes, gloss over risks, or wade into questions that can’t be answered. Speak either straightforwardly or not at all.
Think long term. Don’t worry about short-run profits. This sends the wrong message to team members that they are expendable.
Make team members feel important. Every person has an important role to play in resolving the crisis. Find that role and instill it.
Find a story. Use simple narratives, not complicated PowerPoint slides, to convey your vision; be forward looking. Recall Churchill’s message: “This is not the end, it is not even the beginning of the end, but it is the end of the
beginning.”
Source: A. Wheat (2001), “What It Takes,” Fortune (November 12), 126.
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Reputation and Influence Decision makers often rely on the advice of people with established reputations. This tendency is emphasized by
H. Mintzberg:
I found that chief executives faced complex choices. They had to consider the impact of each decision on other decisions and on the organization’s strategy. They had to ensure that the decision would be acceptable to those who influence the organization as well as ensuring that resources would not be overextended. They had to understand the various costs and benefits as well as the feasibility of the proposal. They also had to consider questions of timing. All this was necessary for the simple approval of someone else’s proposal. At the same time, however, delay could cost time, while quick approval could be ill considered and quick rejection might discourage the subordinate who had spent months developing a pet project. One common solution to approving projects is to pick the man instead of the proposal. That is, the manager authorizes those projects presented to him by people whose judgment he trusts.
Source: H. Mintzberg (1975), “The Manager’s Job: Folklore and Fact,” Harvard Business Review (July–August), 49–61.
Chapter 20 Leadership: Motivating Change within Organizations 20-13
building the first Macintosh in 1976, being fired in 1985 for his erratic nature, fol- lowed by his 1996 triumphant return to lead Apple. Throughout this experience Jobs has been called a “transformational leader,” a commercial innovator, cultural inspira- tion, and entrepreneurial icon. His passionate perfectionism created the soul of many new machines—iMacs, iBooks, iPods—and altered the way people compute, play music, and view video. Victor Vroom at the Yale School of Management says, “[Jobs] is the supreme example of the transformational leader who stands for higher-order values . . . he has caused people to do things they might never have done before.” Since his return as CEO, Apple’s stock price has risen from below $10 to over $60.10
A sponsor also can increase support for a proposal by obtaining the endorsement of other managers with good reputations. Therefore, it is often useful to conduct de- tailed discussions with these managers. If they agree with the analysis, it is more likely that it is correct. Moreover, their endorsements will garner additional support and forestall opposition from elsewhere within the organization.
Emphasizing a Crisis
A complementary strategy to overcome the normal preference for the status quo is to argue that the current situation is worse than people currently recognize. The popu- lar literature frequently argues that employees are most likely to favor change when an organization faces a crisis: If change doesn’t occur, the organization is going to fail. Managers can promote a willingness to change if they can convince employees that the firm faces a crisis. Kearns gained support for his program at Xerox by re- peatedly highlighting the threat from Japanese competition. Of course, this strategy works best if in fact the firm faces an actual crisis. Individuals understand the incen- tives that proponents of proposals have to state that the organization faces a crisis and correspondingly are unlikely to accept this argument unless it is credible. In the case of Xerox, it was easy to document the lost business. Also, it was easy to point to other industries, such as steel and automobiles, which were having similar experi- ences. The effect of this action is to reduce employee assessments of the utility asso- ciated with the status quo. This shift enlarges the support region, similar to the analy- sis in Figure 20.2. Thus, Chris can gain Lynn’s support if he provides her with new information that causes her to be less optimistic about the status quo. In the appen- dix, we illustrate how an employee’s attitude toward change can depend on whether the firm faces a crisis.
M A N A G E R I A L A P P L I C AT I O N S
Wage Concessions at United In November 2002 United Airlines announced that it had negotiated wage concessions totaling $5.4 billion from its
employees. These reductions were accepted by United’s unions to help the firm avoid bankruptcy. Given the fall in
demand and increases in costs following the September 11, 2001, terrorist attacks as well as the bankruptcy filing by
U.S. Airways, it certainly was credible for United to argue that the status quo was not sustainable.
Source: M. Maynard (2002), “United and Machinists Reach Deal on Concessions,” The New York Times (November 21), C1.
10Source: www.usnews.com/usnews/news/articles/051031/31jobs.htm; and http://en.wikipedia.org/wiki/
Steve_ Jobs.
20-14 Part 4 Applications of Organizational Architecture
Organizational Power Economics suggests that an employee’s attitude toward change will depend on the per- sonal effects of the proposal. These effects are likely to depend on the identity of the sponsor. Some proposal sponsors have more personal power than others to affect the payoffs received by other employees. To be effective, it is important for managers to understand the sources of this power and how to acquire it.
Sources of Power11
What is the source of power within organizations? There are no laws that require people to obey or support the wishes of others within the firm. Corporate power does not come from the ability to force others to follow commands. Ultimately, it comes from other people who voluntarily agree to comply with a leader’s wishes or pro- posals. For this voluntary action to occur, it must be in the interests of these people to cooperate with the leader. This section discusses potential sources of power and influence.
Formal Authority Some power comes from the formal position within the organization. If a manager has the right to fire, promote, and compensate an employee, the employee obviously has an economic incentive to comply with the manager’s wishes.12 In our example, Chris can count on some support from his employees even if the employees think that the proposal will harm them because not supporting it might harm them even more—Chris might be less supportive of raises or promotions; he might even fire them. For instance, these employees are likely to speak in favor of the proposal at public meetings. In addition, his formal authority gives Chris the
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Leaders Require Followers Ben Hermalin at the University of California, Berkeley, argues that since leaders must have followers, and since
following is a voluntary act (one cannot coerce followers to follow), then to understand what makes leaders, one should
understand what causes followers to follow. In other words, followers determine their leaders. And a leader’s reputation
for honesty and trustworthiness is what motivates followers.
Anu Shukla, founder of RubiconSoft, learned the value of faithful followers. When she started Rubric, several of
her employees followed her from Compuware, where she started as vice president for marketing. After selling Rubric
for $386 million, she started a new venture RubiconSoft, and several of her former colleagues followed her to her new
venture, some even becoming investors. Ms. Shukla understands the value of retaining talented employees. “It was a
very competitive time in the technology industry, with companies all stealing talent from each other. I saw the value of
working with people over time and making sure they stuck with me.”
Source: B. Hermalin (1998), “Toward an Economic Theory of Leadership: Leading by Example,” American Economic Review 88, 1188–1206; and C. Hymowitz (2004), “In the Lead: The Best Leaders Have Employees Who Would Follow Them,” The Wall Street Journal (February 10), B1.
11This section draws on Pfeffer (1992). 12Assuming the employee cannot shift to a comparable position costlessly at another firm.
Chapter 20 Leadership: Motivating Change within Organizations 20-15
right to make certain decisions without consulting others. But power attached to a formal position is not without limits. There is the usual incentive problem that em- ployees might ignore their manager’s wishes. Also, employees can take actions to get the manager replaced (a “palace revolt”). Disgruntled employees might form a coalition to complain to the CEO that Chris is incompetent. Finally, some compa- nies conduct 360-degree performance reviews where employees provide formal input into the performance evaluations of the managers.
Control of Budgets and Resources People are granted rights to control resources within organizations. Some individu- als have budget authority, and others decide on the allocation of office space or the priority for using copy machines. Control over these resources is a source of power. Individuals are reluctant to challenge a person who controls an important resource because they fear that it will affect their access to this resource. For example, de- partment managers might support Chris because he controls the budget from which they receive funds.
This discussion suggests that individuals can increase their organizational power by gaining control over key resources. This concept can be important in de- ciding whether to apply for a particular job or task within the firm: Jobs and tasks are more attractive if they contain decision rights over resources others value. Also, a person sometimes can create power by developing a service or product that becomes important to other people within the organization. For example, the data processing manager in a company might increase personal influence and power by offering a repair service for computers within the organization. This action will create greater power if the firm prohibits the use of external vendors, requiring em- ployees to use this internal service for computer repair.
Throughout this book, we have argued that it is important to link decision rights and specific knowledge. Our current discussion suggests a secondary factor that executives might consider in assigning decision rights over key resources: It can be
Power and Resource Control—Voting on Antitakeover Amendments Economic theory suggests that the control of important resources provides a person with power. Other people are afraid
not to support the person’s proposals because they fear that they will lose access to the important resource.
An illustration of the importance of this argument is provided by studies of corporate voting on antitakeover
amendments. These amendments make it more difficult for outsiders to take control of a company through a corporate
takeover. The existing evidence suggests that some of these amendments reduce the wealth of shareholders but benefit
incumbent managers who become more secure in their jobs. The decision on whether to adopt these management-
sponsored amendments is held by the shareholders, who would appear to have the incentives to vote against the
amendments. Management, however, has power over certain institutional investors, such as banks and insurance
companies, because they derive business from the firm, which is under management control: If they don’t vote in favor
of management-sponsored amendments, they risk losing important business. Empirical evidence indicates that these
types of institutional investors are more likely to support management-sponsored antitakeover amendments than other,
more independent, investors. The evidence also suggests that management groups who lack the power to get
amendments passed tend not to propose amendments because they do not want to bear the reputation costs of proposing
an amendment that fails.
Source: J. Brickley, R. Lease, and C. Smith (1994), “Corporate Voting: Evidence from Charter Amendment Proposals,” Journal of Corporate Finance 1, 5–31.
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20-16 Part 4 Applications of Organizational Architecture
important to grant power to managers who have the most potential to increase firm value.13 For example, suppose that an executive can assign decision rights over cor- porate computing to one of two divisional managers, Sanjai Kumar or Maria Lopez. Both managers have the specific knowledge to manage the computer resources ef- fectively. Sanjai, however, has a greater potential to affect the firm’s value through his proposals than Maria (Sanjai manages a division with greater opportunities to create value). Further, Sanjai’s proposals require the support and cooperation of em- ployees in other divisions of the firm. In this case, the executive might want to assign the decision rights over computing to Sanjai, since they will give him control over additional resources that he can use to persuade others to support his proposals.
Control of Information A particularly important resource in most organizations is information. The infor- mation held by any particular employee depends on things like the employee’s posi- tion, office location, social network, and special skills. Not all employees have equal access to information. Since most employees require various types of information to be effective in their jobs, people with information have power—they can trade infor- mation for support. Some employees at BCT might support Chris because they de- pend on him to keep them informed about what is going on in the company. Individ- uals can attempt to increase their access to information (and power) by lobbying for centrally located office space (e.g., at the corporate headquarters), developing a so- cial network within the organization, applying for jobs that are “in the information loop,” or volunteering for key committee assignments.
Viewing the firm as the focal point for a set of contracts (see Chapter 10) pro- vides a useful way to think about the control of information in a firm. Under this view, the firm is characterized as a network of contracts between the firm and other parties such as suppliers, customers, and employees. Many of these contracts are in- formal, and important information is held by people at the various contracting nodes. Controlling access to this information can vest a person with substantial power. It would be quite difficult for a firm to fire an employee who has been the primary contact with a key customer for 20 years. The employee possesses specific
M A N A G E R I A L A P P L I C AT I O N S
The Power of Information: Evidence from a French Tobacco Factory An interesting example of the power of information comes from a French cigarette plant in the 1960s. The equipment
in this plant was highly automated and subject to mechanical failures. The manuals that explained how to repair this
equipment had been destroyed in a fire, and the only people with the knowledge to fix the machines were the
maintenance engineers at the factory. This monopolistic access to important information gave the engineers enormous
power. Without them, the plant could not run, and it was impossible to replace them. Indeed, the engineers had
sufficient power to have a managing director of the company removed from his job. When new engineers were trained
in the plant, they were instructed verbally and asked to destroy any notes once they mastered the material. These
actions helped these engineers maintain their power over time.
Source: M. Crozier (1964), The Bureaucratic Phenomenon (University of Chicago Press: Chicago).
13This point relates to Hart’s argument that the allocation of power and control of resources can affect
investment decisions and thus value. O. Hart (1995), Firms, Contracts, and Financial Structure (Oxford Press: Oxford).
Chapter 20 Leadership: Motivating Change within Organizations 20-17
information on issues from company promises to customer requirements, and turnover in this position would be costly for the firm.14
Friends and Allies Having close personal ties with decision makers increases the likelihood that they will act on your behalf. Managers sometimes hire or promote their friends into key positions over more qualified candidates. One reason for such actions is that the managers expect that their friends will provide support. Some employees make a point of doing favors for other individuals within the firm (e.g., providing assistance on difficult projects or fill- ing in for other people when they are on vacation) to increase the likelihood that these individuals will support them in the future. Chris is more likely to obtain support for his proposal if he has developed allies within the company.15 Concerns over inappropriate concentrations of power have led some firms to adopt policies with respect to nepotism.
Tying the Proposal to Another Initiative
Sometimes it is possible to free-ride on the power of other people in the firm to gain support for a proposal. Perhaps, in our example, BCT’s CEO has stressed the impor- tance of product quality to the media and to customers through a program entitled
Logrolling in Government and Business Many of the classic examples of logrolling come from government. For example, one stylized example involves big
business, unions, and farmers, where a winning coalition consists of any of the two groups. Farmers have an advantage
in this setting because their demands are less likely to be inconsistent with the demands of unions or big business while
the demands of big business and unions are more likely to be inconsistent with each other. Indeed, farmers often want
things that are relatively unimportant to the other two groups. Farmers, in turn, often don’t care much about the
demands of the other groups. This mutual indifference makes farmers good partners in a coalition. In contrast, big
business and labor unions are likely to make a poor coalition. This helps explain why farmers have been unusually
successful in getting favorable regulation established by the government.
Although many of the examples of logrolling come from government, it is also prevalent in most types of
organizations. For example, a marketing executive and a manufacturing manager might form a logroll to provide mutual
support for each other’s funding requests. In contrast, two manufacturing executives who are interested in mutually
exclusive projects would not enter into a coalition. To quote Professor James March,
Logrolls are found not only in the United States Congress, but also in business firms, military organizations, and universities.
Source: J. March (1994), A Primer on Decision Making (Free Press: New York), 157–159.
A C A D E M I C A P P L I C AT I O N S
14Andre Shleifer and Robert Vishny argue that managers sometimes choose investment projects that give them
an informational advantage and thus make it more costly for shareholders to replace them. A. Shleifer and
R. Vishny (1989), “Management Entrenchment: The Case of Manager-Specific Investment,” Journal of Financial Economics 25, 123–139.
15For an economic analysis of gift giving and exchange, see G. Akerlof (1982), “Labor Contracts as Partial
Gift Exchange,” Quarterly Journal of Economics 97, 543–569; and J. Rotemberg (1994), “Human Relations in the Workplace,” Journal of Political Economy 102, 684–718.
20-18 Part 4 Applications of Organizational Architecture
“Quality 2006.” Chris might claim that his proposal is an integral part of the CEO’s vision for the company and fits nicely within the Quality 2006 program. Casting up the proposal in this manner makes it less likely that other employees will raise ob- jections because they will hesitate to argue against an important initiative sponsored by the CEO.
Coalitions and Logrolling16
A manager sometimes can increase power through logrolling. A logroll consists of a coalition of individuals who are largely indifferent to one another’s proposals but agree to support the various requests so that each can get what he or she wants. A classic example is the coalition that forms each year in the U.S. Congress to pass the Rivers and Harbors Act. This act contains many local projects that individually would receive support from only a few legislators. Yet this act regularly passes by a comfortable majority because legislators band together to provide mutual sup- port for one another’s proposals. In our example, Chris might form a logroll with other general managers in the company to support his proposal. He can agree to support proposals by these managers to expand their divisions if they back his quality proposal. In business firms (as in many other settings), these types of agreements virtually always take the form of implicit promises or understandings rather than formal contracts. However, in some cases the scope of the proposal can be expanded so that provisions valued by other managers can be included in the package. As in the case of the Rivers and Harbors Act, any quid pro quos are ex- plicit and potential coalition defections are less troublesome if the issues can be considered simultaneously.
Coalition Obstacles In trying to form a logroll, Chris should anticipate at least two potential problems. First is the issue of credible promises. Major decisions in firms do not occur si- multaneously. He might need immediate support from other managers, whereas proposals from these managers might not be considered until later. Other man- agers might be reluctant to support Chris because they fear that he will not follow through on his part of the bargain. Second, identifying potential candidates for the
M A N A G E R I A L A P P L I C AT I O N S
Logrolling at General Motors J. L. Pratt, who was chairman of General Motors’ Appropriations Committee, noted that there was no corporate
headquarters coordinating the company’s various divisions before Alfred Sloan became CEO. The Executive
Committee was composed of division managers. “When one of them had a project, why he would get the vote of his
fellow members; if they would vote for his project, he would vote for theirs. It was a sort of horse trading.”
Source: A. Chandler (1962), Strategy and Structure (MIT Press: Cambridge), 127.
16This section draws on W. Riker (1962), The Theory of Political Coalitions (Yale University Press: New Haven).
Chapter 20 Leadership: Motivating Change within Organizations 20-19
logroll is not always easy. There is likely to be asymmetric information about how the proposal affects other people’s welfare. Chris does not know for certain who is indifferent to his proposal. Individuals who are truly indifferent might claim that they would be harmed by the proposal and are unwilling to support him un- less he makes many concessions to their wishes. This type of strategic misrepre- sentation can result in bargaining failures—in this case, the logroll might fail to materialize. Despite these problems, however, effective coalitions often are formed. Indeed, this type of deal making, or “horse trading,” is common within organizations.
Proposal Detail and Logrolling As we discussed, Chris is concerned not only about getting his proposal adopted, but also about incentive problems that could occur after the program is under way. He can reduce these incentive problems by being quite specific about what is expected of each key employee (so he leaves little discretionary decision authority). This strat- egy, however, entails two potentially significant costs: First, it limits the ability of employees to act on their specific knowledge in the implementation phase. In this sense, Chris faces a basic trade-off in project design that we have emphasized throughout this book—the trade-off between the effective use of specific information and incentive problems. Second, being overly specific in the ratification phase can make it more difficult for Chris to assemble an effective coalition. Logrolling often requires that terms of the proposal be somewhat vague to limit potential conflicts. Specific proposals provide employees with greater opportunities to argue about details.17
Is Organizational Power Bad?
We have argued that leaders often use personal power and political skills to motivate change within organizations. Yet words like power and politics frequently connote negative images to many people. It is easy to conjure up visions of Machiavelli of- fering insidious advice to the prince on how to increase his power. Similarly, one eas- ily can envision managers becoming completely absorbed in office politics.
Obviously, attempts to gain power involve costs. For instance, having key em- ployees spend time on logrolling can be expensive. In Chapter 12, we discussed how
Political Skills and Organizational Productivity The development and exercise of power in organizations is about getting things accomplished. The very nature of
organizations—interdependent, complex systems with many actors and many points of view—means that taking action
is often problematic. Failures in implementations are almost invariably failures to build successful coalitions. Although
networks of allies can obviously be misused, they are nevertheless essential in order to get things done.
Source: J. Pfeffer (1992), Managing with Power (Harvard Business School: Boston), 108.
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17J. March (1994), A Primer on Decision Making (Free Press: New York), 170–171.
20-20 Part 4 Applications of Organizational Architecture
these influence costs can affect the appropriate architecture of the organization. Firms that survive in the marketplace are likely to be those which effectively limit unproductive uses of employee time. It also is important to recognize that power and political skills can provide important benefits. Organizations involve people working together. Without political skills and power, leaders might fail to implement value- increasing plans and the organization would suffer immensely.
In summary, power and political skills are, in and of themselves, neither good nor bad. They are important attributes that can be used for either productive or unpro- ductive purposes. Managers would be naive to think that they could be effective without such attributes.
The Use of Symbols Our analysis thus far in this chapter has focused on the formal organizational ar- chitecture and strategies for garnering support for proposals. The popular litera- ture often stresses that effective leadership requires the clever use of symbols such as role modeling, formal creeds, stories, and legends. For example, an executive interested in increasing customer service might take the time to talk to customers directly—ensuring that these actions are visible to other employees through media releases and videotapes. The executive might retell stories about employees who have gone out of their way to serve customers. The company also might adopt formal creeds and statements to emphasize the manager’s basic vision for the company.
We view such symbols as an aspect of corporate culture that performs a poten- tially important communication function; the symbols inform employees about what is valued in the company. But again, symbols are unlikely to be effective in motivat- ing employees to take particular actions unless reinforced by the firm’s performance- evaluation and reward systems. David Kearns came to realize this and ultimately had to change the reward system at Xerox before he could implement his quality program successfully.
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The Use of Symbols at Nordstrom Nordstrom is a department store chain, that is, famous for stressing customer service and satisfaction. The vision of
the Nordstrom family (who manage the firm) is to offer the customer the best in service, selection, quality, and
value.
The importance of customer service is stressed to employees by the frequent telling of stories about sales clerks
who performed such heroics as changing a customer’s flat tire in a store parking lot, paying a customer’s parking
ticket, and lending money to a customer who was short on cash to make a purchase. One particularly interesting story
is the one about the sales clerk who refunded money to a customer irate about some newly purchased tires. The clerk
cheerfully refunded the money even though the customer did not have a receipt. The fascinating part of the story is that
Nordstrom does not sell tires!
Nordstrom does not rely on these types of stories alone to motivate employees to provide customer service. It has
an extensive incentive system that stresses sales and customer service.
Source: H. Weston (1991), Nordstrom: Dissension in the Ranks, Harvard Business School Case, N9-191-002.
Chapter 20 Leadership: Motivating Change within Organizations 20-21
Summary This chapter uses the framework developed in Chapters 11–17 of this book to pro- vide insights into more effective leadership. The analysis presents an important ex- ample of how this framework can be used to provide a structured discussion of this popular, but not necessarily well-understood, topic.
The leadership literature stresses two important tasks that all leaders must perform—setting goals and motivating employees. To accomplish these tasks, man- agement must design decision-right, performance-evaluation, and reward systems that effectively link relevant specific knowledge with decision-making authority and provide appropriate incentives for decision makers to act on their information. In this sense, much of this book has focused on key components of leadership.
ANALYZING MANAGERIAL DECISIONS: Global Insurance
Global Insurance is a disability insurance company.
Traditionally, it has organized its corporate head-
quarters around functional specialties. After an
application for an insurance policy arrives at head-
quarters from a field agent, it is processed through
a series of functional departments. One department
checks to see if the application is filled out cor-
rectly, another department checks the medical his-
tory of the applicant, and so on. Among the final
steps is the underwriting decision, where the
company agrees to accept the policy. This task is
handled by trained underwriters.
One of the more important departments at
Global is human resources. The human resources
department administers the personnel system (for
instance, screening job applicants, reviewing pro-
motion decisions, having key decision rights on
salary levels and job classifications, and providing
training throughout the organization). Currently,
the system includes nearly 2,000 discrete job titles.
The director of human resources is viewed by most
employees as a key person in the organization.
A major problem at Global is that it takes nearly
a month to process an insurance application. Appli-
cations can sit for days in in-boxes, as they move
from department to department. Global’s CEO has
decided that the company must reorganize to remain
competitive. He has a vision to do away with most
of the functional departments. Insurance applications
would be handled by caseworkers responsible for all the steps from initial inspection of the application
through underwriting. These caseworkers would be
supported by a computer system that would allow
access to medical record databases and other infor-
mation necessary for processing an application.
The management information system manager
would be charged with developing the information
system. Caseworkers would receive training in un-
derwriting from the existing underwriters in the
firm. Entry-level caseworkers would be required to
have at least a two-year degree from a community
college. The number of job titles would be reduced
significantly. Most of the people would have titles
like associate or partner. Training, promotion, and hiring rights, currently held by human resources,
would be decentralized to senior case managers
(partners). The human resources department would
play an important role in transitioning to the new
system (dismantling existing training programs and
turning them over to case managers, reducing the
size of its staff, and so on). Through similar pro-
grams, other insurance companies have been able
to reduce their application processing times dra-
matically. They also have reduced their workforces
significantly.
1. Which employees in the organization do you
think will oppose the new proposal? Who will
support it?
2. What problems can the opponents cause in
implementing the plan?
3. What actions should the CEO take to increase
the likelihood that his plan will be imple-
mented successfully?
20-22 Part 4 Applications of Organizational Architecture
Academic discussions often treat the process of decision ratification as a purely intellectual exercise. In most firms, however, the decision process involves signifi- cant incentive problems. As a result, decision making in firms often resembles deci- sion making within political settings.
Effective leadership is facilitated by careful consideration of other employees’ perspectives on proposals for change. It is important to recognize that people typ- ically are risk-averse and interested in their own well-being. An important factor to consider is the existing organizational architecture. How will a proposed change affect specific employees in terms of their decision rights and rewards from the organization?
Managers can make two general types of changes in architecture that can assist in gaining support for their proposals. First, they can identify individuals who are po- tential supporters of their proposals and give them increased decision rights. Second, they can change the performance-evaluation and reward systems so that it is in the self-interest of more employees to support their suggestions.
Developing proposals that can be discontinued at low cost can reduce opposition. Flexibility, however, has costs as well as benefits. Sometimes it is better for man- agers to demonstrate a greater commitment to a change so that employees take the change more seriously. Managers can analyze the incentives of key decision makers and design proposals that are more likely to be supported.
The sponsor often will have information that can affect other employees’ assess- ments of a proposal. The sponsor might be able to convince other employees of the merits of the proposal through careful analysis and groundwork, relying on a reputa- tion for good decision making, and/or emphasizing a crisis.
Some managers have more personal power than others to affect the payoffs to other employees. Power within organizations generally does not come from the abil- ity to force others to follow commands. Rather, power comes from other people who voluntarily agree to comply with a leader’s proposals. For this voluntary action to occur, it must be in the interests of these other people to cooperate with the leader. Sources of power include formal authority derived from the position in their firm, control over important physical or budgetary resources, control over information, and friends/allies. Sometimes it is possible to use the power of another employee by tying the proposal to a program backed by the powerful employee.
Employees can gain support for proposals by logrolling. A logroll consists of a coalition of individuals who are largely indifferent to one another’s proposals but agree to support the various requests so that each can get what he or she wants.
Words like power and politics often conjure up negative images. Our view is that power and political skills are neither universally good nor bad. Rather, they are im- portant attributes that can be used for either productive or unproductive purposes. Managers are naive if they think that they can be effective without such attributes.
Symbols such as role modeling, formal creeds, stories, and legends can play an important role in communicating a manager’s vision to employees. However, they are unlikely to be effective in motivating employees to take particular actions unless they are reinforced by the firm’s performance-evaluation and reward systems.
J. Gardner (1990), On Leadership (Free Press: New York).
D. Kearns and D. Nadler (1992), Prophets in the Dark (Harper Business Press: New York).
D. Kreps (1990), “Corporate Culture and Economic Theory,” in J. Alt and K. Shepsle (Eds.),
Perspectives on Positive Political Economy (Cambridge University Press: Cambridge).
Suggested Readings
Chapter 20 Leadership: Motivating Change within Organizations 20-23
J. March (1994), A Primer on Decision Making (Free Press: New York).
J. Pfeffer (1992), Managing with Power (Harvard Business School: Boston).
20–1. What is leadership?
20–2. It is frequently claimed that meaningful change is difficult to achieve in large companies. Why do you think this might be the case?
20–3. What does leadership have to do with organizational architecture?
20–4. What is organizational power, and where does it come from?
20–5. The PPP Company recently purchased a large chain of supermarkets (over 1,000 stores). Following this acquisition, PPP’s management announced its plan to cut labor costs dramat-
ically so that the stores could remain competitive. Labor unions responded by saying that
they would not agree to large wage cuts. After negotiating with a labor union for a short
time, PPP announced that it was closing several of its most profitable stores because labor
would not agree to wage cuts. On the surface, this seemed like a silly move, given that the
stores were profitable. Why do you think PPP made this move?
20–6. The TRF Company has not fared well with recent increases in foreign competition. Man- agement indicates that it must substantially cut costs to survive. Cost cutting entails dra-
matic change for the company. TRF had been an all-equity firm. Recently, the company
borrowed nearly 90 percent of its value and used the money to repurchase shares. The
required annual debt payments exceed the company’s realized earnings over the past few
years. What might have motivated management to make this dramatic increase in leverage,
given that it placed the firm in a near “financial crisis”?
20–7. Alex Cohen is the general manager of the textile division in a large diversified company. Recently, Alex argued strongly to the CEO that an expansion request by the drug division
be approved. On the surface, Alex’s actions seem strange, given that Alex is not affected
by this decision (it does not affect his budget or his compensation). Further, Alex spent
substantial time developing his presentation for the CEO.
a. Why do you think Alex took such an active role in supporting the drug division’s request?
b. Since Alex is not affected by the decision, should the CEO consider Alex as an unbiased observer who is focused on trying to maximize company value? Explain.
20–8. Poorly performing employees in Japanese firms are sometimes punished by being sent to remote locations or placed at desks away from their colleagues. Discuss the effects that
such a penalty will have on the leadership effectiveness of the punished employees.
Appendix: In this chapter we discussed how a crisis and a leader’s demonstrated commitment to Strategic change sometimes help motivate change within an organization. In this appendix we Value of use a simple game-theoretic example to illustrate these ideas. Commitment Tomoka Hayashi is chief financial officer of the GSA Company. Simon and Crisis Lewellen is the general manager of the company’s largest division. The board of
directors is scheduled to meet next week. Tomoka will recommend the firm’s leverage ratio for the next year. She will recommend either high leverage, where the firm will borrow money to repurchase common stock, or low leverage, where the company maintains its current low debt-to-equity ratio. Simon will recom- mend whether his division should invest in a major new technology. The board is expected to accept Tomoka’s and Simon’s recommendations.
Figure 20.4 displays the personal payoffs to Tomoka and Simon for the four pos- sible combinations of leverage and investment. Tomoka prefers low leverage and
Review Questions
20-24 Part 4 Applications of Organizational Architecture
investment in the new technology, whereas Simon prefers low leverage and not in- vesting in the new technology.18 Tomoka, however, prefers high leverage and invest- ing to low leverage and not investing. Currently both are scheduled to make their first public disclosures of their recommendations at the board meeting. This schedule ef- fectively requires them to make simultaneous announcements. Each must prepare extensive presentations supporting their recommendations. It is unlikely that either person will want to change his or her recommendation in the middle of the board meeting: Board members might view such a change as troublesome evidence with respect to that person’s abilities. The Nash equilibrium is for Tomoka to propose low leverage and for Simon to propose no new investment.19
Tomoka potentially can affect Simon’s choice by committing to propose high lever- age. Simon views high leverage as placing the firm in a financial crisis. If the com- pany does not invest in the new technology, the firm will not generate sufficient cash flow to service the debt, the firm will go bankrupt, and both will lose their jobs. The new technology, on the other hand, is likely to generate enough cash flow to avoid this outcome. If Simon were convinced that Tomoka would recommend high leverage, he would propose investing in the new technology. She might effectively commit to high leverage by announcing to the financial press that she intends to make this recom- mendation. Simon will realize that Tomoka has “backed herself into a corner”; surely she would not alter her recommendation—it would ruin her reputation as a decisive
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Figure 20.4 Strategic Value of Commitment
Tomoka Hayashi is CFO of the GSA Company, and Simon Lewellen is the general manager of the company’s largest division. At the next board meeting Tomoka will recommend the degree of leverage; Simon will recommend whether his division should invest in a new technology. If they both wait until the board meeting to announce their policy choices, the Nash equilibrium is low leverage and no investment. Tomoka may be able to achieve a preferred outcome—high leverage and investment—by effectively committing to recommend high leverage prior to the meeting.
18Tomoka anticipates that the new technology will increase the firm’s value. As CFO she is evaluated based on
the stock-price performance of the company. She favors low leverage because of its lower likelihood of
bankruptcy. Simon, on the other hand, views the investment as more work for him, with little direct personal
benefit. Also, the new investment will reduce his division’s reported profits for a few years (there are initial
start-up expenses, and it will take some time to build sales) and thus the size of his annual bonus. He expects
to retire in three years and will not be with the firm when the division begins reporting higher profits. 19Simon knows that Tomoka will recommend low leverage regardless of what she expects him to do. (Holding
Simon’s recommendation fixed, she always receives a higher payoff by recommending low leverage.) Thus,
Simon’s optimal strategy is to recommend not to invest in the new technology.
Chapter 20 Leadership: Motivating Change within Organizations 20-25
CFO. To affect his choice, it is important that Tomoka’s commitment is binding. If he is not convinced, he is more likely to recommend not to invest, expecting that she will recommend low leverage to the board. Simon also might be able to influence the out- come in his favor by being the first to commit to a specific recommendation—in this case, to reject the new technology.
Appendix Question The analysis in this appendix suggests that a leader can sometimes motivate desired change by making a strong commitment to a particular action. Do you think it is always in the leader’s interest to make this type of commitment? Explain.
chapter
21 C H A P T E R O U T L I N E
Importance of Regulation to Managers
Economic Motives for Government Intervention
Defining and Enforcing Property Rights
Redressing Market Failures
Redistributing Wealth
Economic Theory of Regulation
Demand for Regulation: Special Interests
Supply of Regulation: Politicians
Market for Regulation
Deadweight Losses, Transaction Costs, and Wealth Transfers
Managerial Implications
Restricting Entry and Limiting Substitutes
Forming Coalitions
On Business Participation in the Political Process
Summary
I n May 1998, the U.S. Justice Department charged Microsoft Corp. with crushing competition and stifling innovation in the software industry.1
Even though the lawsuit had been rumored widely, Microsoft shares still fell 3.8 percent upon filing the legal action. Nineteen states ranging
from California to New York joined the suit. This litigation alleged that Microsoft’s long-standing practice of adding features to its Windows operating system without a separate charge amounts to predatory pricing: It drives out existing competitors and dissuades other firms from entering the software market. In particular, Microsoft was accused of damaging rivals Netscape and Sun Microsystems.
The federal government contended that Microsoft has used its Windows, which was installed on 90 percent of new machines, to pressure personal computer makers to favor Microsoft’s browser over Netscape’s. Offered as evidence were records of a meeting between Microsoft and Netscape executives in June 1995 where Microsoft allegedly proposed dividing the browser market between the two companies. At the trial in October 1998, Microsoft argued that it was “set up” by Netscape. Accord- ing to Microsoft, Netscape used the June 1995 meeting to create a record that could be passed to the Justice Department to further its case against Microsoft.
Understanding the Business Environment: The Economics of Regulation
1J. Wilke (1998), “U.S. Sues Microsoft on Antitrust Grounds,” The Wall Street Journal (May 19), A3; “Microsoft Says It Was ‘Set Up,’” Democrat and Chronicle (October 27, 1998), D12; D. Bank (1998), “Is Microsoft a New Public Utility?” The Wall Street Journal (May 19), B1; and M. France, P. Burrows, L. Himelstein, and M. Moeller (1999), “The Microsoft Ruling,”
BusinessWeek (November 22), 38–41.
L E A R N I N G O B J E C T I V E S
1. Discuss the importance of the regulatory environment to corporate managers. 2. Describe the role of government intervention in the marketplace in defining and
enforcing property rights, in dealing with potential market failures, and in the
redistribution of wealth.
3. Illustrate a basic explanation of the economic theory of regulation and the market for regulation.
4. Explain how regulation can be used to promote market power by restricting entry by potential competitors.
5. Discuss business participation in the political process.
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The government’s case was based on the assumption that the PC operating system is an “essential facility.” So many people rely on their Windows-based computers that software “competitors now need the hand of government to give them a place on the PC screen.” Microsoft had acquired a virtual monopoly in the market for PC op- erating systems—but by itself, that was not illegal. The government also had to show that the company used predatory practices to restrain trade. For example, the gov- ernment made much of a quote from a Microsoft vice president who stated that it was “necessary to fundamentally blunt [Sun Microsystems’] Java to protect our core Windows assets.” But Microsoft Chairman Bill Gates scoffed at the idea that such statements indicate illegal actions. “It’s no surprise to me that there are quotes from inside Microsoft that say, ‘Let’s compete, let’s do a better product.’” Microsoft de- fended its actions by arguing that consumers have not been harmed and that “this suit is about Microsoft’s right to innovate.”
One remedy the government considered would be to prohibit Microsoft from dictating what Internet content appears on the Windows desktop. For example, users seeking travel reservations on the Web were routed to Microsoft’s Expedia site. Such routing was unfair, claimed Terrell Jones, president of Sabre Interactive, which operated the competing travel-arrangement site, Travelocity. Jones claimed that Microsoft denied him a favored position on desktops.
On November 5, 1999, U.S. District Judge Thomas P. Jackson concluded that Microsoft routinely used its monopoly power to crush competitors. Judge Jackson’s fact findings were so critical of Microsoft that the breakup of Microsoft became a real possibility. After two year of appeals, legal maneuvering, and a new president in the White House, on November 2, 2002, U.S. District Court Judge Colleen Kollar- Kotelly accepted a settlement between Microsoft and the Justice Department. The agreement prevents Microsoft from participating in exclusive deals that could hurt competitors, allows manufacturers and customers to remove icons for some Microsoft features, and requires Microsoft to release certain types of sensitive technology to its rivals so software developers can write programs for Windows that work as well as Microsoft products do. Microsoft settled several state lawsuits that alleged the agree- ment with the Justice Department was insufficient to protect Microsoft’s competitors. In 2003 Microsoft agreed to pay California up to $1.1 billion to settle that suit.
Importance of Regulation to Managers Recall Figure 11.1, which provides a flowchart of the framework underlying this book. In that figure the external business environment—technology, markets, and reg- ulation—drives the firm’s choice of business strategy and in turn the firm’s organiza- tional architecture. Numerous examples have been provided throughout the book re- garding how the three legs of the organizational architecture stool can become unbalanced when the firm’s business environment and its strategy change. In Chapter 8 we discussed how a firm might develop a business strategy that both creates con- sumer value and allows the firm to capture that value.
In the federal and state lawsuit against Microsoft, government regulators argued that they were trying to protect consumers by fostering competition. Yet government regu- lation often limits entry into industries. For instance, electric utilities explicitly were granted effective monopolies to supply electricity to customers within specific geographic regions. New entrants were prohibited from building generating plants or selling electricity at lower prices. As states now deregulate power production, new companies are competing for customers. This has lowered prices and created new
Chapter 21 Understanding the Business Environment: The Economics of Regulation 657
businesses ranging from consulting firms who advise large power customers about ways of exploiting the new competitive environment to power brokers who buy elec- tric power from new power plant operators and resell it to large consumers of electric- ity. Thus, these regulatory changes have altered firms’ strategies as well as their orga- nizational architectures.
Government regulation takes a variety of forms: The Microsoft lawsuit is only one example of the government regulating business conduct. The following is but a par- tial list of the many ways regulation affects business:
• The U.S. government has enacted an array of antitrust legislation that makes il- legal such practices as collusive pricing that restrict trade.
• The Environmental Protection Agency (EPA) was established in 1970 to limit pollution of air and water by controlling the disposal of solid waste, pesticides, radiation, and toxic substances.
• All companies with publicly traded stock must follow the Securities and Ex- change Commission regulations; for instance, financial disclosure regulation requires that these companies file audited financial statements with the SEC— statements that are prepared in accordance with Generally Accepted Account- ing Principles.
• Intellectual property laws, price and entry restrictions, labor laws, occupa- tional safety regulations, import and export laws, and immigration acts both protect and constrain commercial activities.
• Some regulations focus on specific industries; for example, financial services (banks, savings and loans, credit unions, mutual funds, investment banks, and insurance companies), energy (electric utilities, gas pipelines, coal, and oil), and transportation (airlines, railroad, and trucking).
• Federal corporate tax rates of roughly 33 percent imply that all firms in effect have a partner who is entitled to almost one-third of the firm’s profits.
This chapter discusses various roles of government including its role in regulating business, how the market for regulation works, and how successful managers manage the regulatory process.
M A N A G E R I A L A P P L I C AT I O N S
Europe Relaxes Its Labor Laws Europe has rather strict worker protection laws that regulate the days people work, their vacations, layoffs, and other
aspects of the employment relationship. One manager said, “we can divorce from our husbands and wives, but we
can’t divorce from our employees.” These laws have made it quite expensive to dismiss employees when business
slowed. This has caused companies to be extremely cautious in expanding within Europe during upturns, preferring to
expand production in less regulated countries, often in Asia. The result has been slow job growth in Europe. But since
the mid-1990s, with the support of politicians, companies are increasingly getting around these restrictive labor laws
by hiring temporary employees—many of the most restrictive laws apply only to permanent employees.
Most European countries now have adopted laws legalizing temporary employee agencies, such as Manpower.
These temp companies provide employers more flexibility to dismiss “long-term temporary help.” And the countries
that have relaxed their labor laws the most have enjoyed the greatest job growth.
Source: H. Cooper and T. Kamm (1998), “Much of Europe Eases Its Rigid Labor Laws, and Temps Proliferate,” The Wall Street Journal ( June 4), A1.
658 Part 4 Applications of Organizational Architecture
Economic Motives for Government Intervention Governments perform various functions; they provide a system of laws and legal in- stitutions that define and enforce property rights, and they address market failures. Markets are said to fail whenever a competitive, unfettered market does not generate an efficient resource allocation for those within the economy. Later we examine a number of reasons for such market failures: Externalities, public goods, monopolies, and information asymmetries. To finance these potentially beneficial government functions of enforcing property rights and resolving market failures, revenues must be raised—usually through taxes. However, governments also use taxes as well as other means to redistribute resources in ways that impose costs on society. We now discuss each of these aspects of government intervention.
Defining and Enforcing Property Rights
When engaging in trade, each party to the transaction generally expects that its rights in the contract will be enforced. If Mark Danchak promises to deliver 200 spring suits to Melanie Caoile’s store next February in return for $20,000 today and $80,000 in April, Mel expects that Mark will deliver the clothing that she ordered and Mark expects that he will receive the $80,000. If the suits do not arrive and she has no legal recourse, her future willingness to buy clothing from his factory is reduced. Similarly, if Mel does not pay the $80,000 she promised and Mark has no legal recourse, his willingness to sell Mel clothing in the future is reduced.
The government creates legal institutions, such as courts, that enforce property rights. To enforce its rulings, the court has access to police powers of the state. If Mark breaches the contract that states he will deliver 200 suits, the court can force him to make restitution. If Mel does not pay, the court has the power to force compliance.
By enforcing contracts between private parties and adjudicating disputes, the gov- ernment reduces transaction costs. With lower transaction costs, there are greater gains from trade, more transactions, more consumer and producer surplus,2 and greater wealth. If Mel could obtain comparable suits from an extremely reputable supplier (one with no risk of default) for $102,000 and she expects to incur more than $2,000 in costs of litigating the transaction with Mark, she will not buy his suits. But if she believes the government will enforce the contract at a cost to her of less than $10 per suit, then she will buy the 200 suits and will have consumer surplus of as much as $2,000. If the government can enforce this contract for less than $2,000, then it’s efficient for the government to perform this role (even ignoring any pro- ducer surplus).
A system of well-enforced, stable property rights increases incentives for people to make investments. Knowing that Mark can sell his output incurring low transac- tion costs supports his incentives to build a suit factory. Not only will more cus- tomers be willing to buy Mark’s products because their transaction costs will be lower, but also his transaction costs will be lower. The government enforces property rights in other ways as well; for instance, Mark expects that the state will provide pro- tection against someone stealing his goods prior to their delivery.
2Chapter 7 defined consumer surplus as the difference between what the consumer is willing to pay and what
is actually paid for a product. Analogously defined, producer surplus is the difference between the price the
producer receives for the product and the cost of producing it.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 659
Most governments enforce patents, copyrights, and trademarks. By granting in- ventors patents (which protect the inventor from others copying their inventions for a stipulated time period), inventors and investors devote more resources to inventive activities. Developing countries without strong patent and trademark protection often have difficulty attracting investment because people fear that their investments will be expropriated.
The transaction costs of writing and enforcing contracts are higher in countries with poorly enforced property rights. For instance in the former Soviet Union, large firms employ their own security forces for protection. Workers frequently are paid in cash because the banking system is unreliable. Delivering the payroll to remote sites re- quires expensive security measures. All these transaction costs reduce gains from trade, lower the volume of transactions, limit investment incentives, and reduce wealth.3
In developed countries, relatively few commercial transactions are litigated. The threat of litigation as well as concerns about one’s reputation—especially in repeated business dealings—cause most businesspeople to honor contracts voluntarily.4
Nonetheless, commercial litigation is a growing problem in the United States. Be- tween 1971 and 1991 more than 4 million federal lawsuits were filed, with almost 2.5 million involving at least one business entity. Moreover, this litigation is quite ex- pensive. Combined wealth losses by firms have been estimated to be 1 percent of their equity value or about $21 million per lawsuit.5 Lawsuits also increase operating costs. For instance, experts argue that one reason health care costs in the United States are so high is that doctors practice defensive medicine—for example, by ordering extra tests to bolster their legal defense in the event that they are sued. Similarly, to limit their liability, few public swimming pools have diving boards. Excessive litigation limits consumers’ choices and thus their welfare.
On the one hand, the legal system can promote efficiency by lowering transaction costs by making property rights more secure; on the other, the legal system can raise costs by creating incentives to litigate frivolous suits. A jury ordered McDonald’s to pay $2.7 million to Stella Liebeck, a drive-through customer who burned herself with hot coffee after placing the cup between her legs to remove the top and add cream:
M A N A G E R I A L A P P L I C AT I O N S
War and Hunger Wars, such as those in Africa, Kosovo, Chechnya, Afghanistan, and Iraq, regularly produce widespread hunger among
the population. During wars, the power of the central government to enforce property rights and contracts is reduced
dramatically. Without protection from the government supporting their ability to reap the rewards of a harvest, farmers
are reluctant to plant crops. Especially near contested areas, farmers fear that their land might turn into a battlefield or
that any crops they grow might be seized by one of the combatants. Agricultural output is slashed due to the reduced
incentives to plant because the farmers’ ability to capture the fruits of their investments is diminished. Besides the
obvious reason that wars create hunger by consuming real resources (labor and property), wars also create hunger by
reducing incentives to invest in agriculture.
3A. Grief and E. Kandel (1995), “Contract Enforcement Institutions: Historical Perspective and Current Status
in Russia,” in E. Lazear (Ed.), Economic Transition in Eastern Europe and Russia: Realities of Reform (Hoover Press: Stanford).
4In Chapter 22, we discuss these issues in greater detail. 5S. Bhagat, J. Brickley, and J. Coles (1994), “The Costs of Inefficient Bargaining and Financial Distress,”
Journal of Financial Economics 35 (April), 221–247.
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She claimed the coffee was just too hot. The U.S. securities acts potentially lower transaction costs in security markets by regulating brokers and requiring publicly traded firms to make timely operating information disclosures. However, these acts also allow investor lawsuits if the firm makes what turn out to be false disclosures. The out-of-pocket cost to plaintiffs of filing such a lawsuit is under $200, whereas the average settlement is $7 million. Such a disparity encourages frivolous suits. (In some countries, the incentive to file frivolous suits is reduced by making the losing party re- sponsible for part of their opponent’s legal expenses.)
Redressing Market Failures
Chapter 3 describes how a well-functioning market provides an efficient allocation of resources without shortages or surpluses. But unregulated markets do not always func- tion well. Externalities, public goods, monopolies, and informational failures can pro- duce “market failures” that limit the efficient allocation of resources. In these cases, some economists argue that an appropriate role of government is to enter and regulate the market to redress the failure. Yet, even after accepting the fact that such market fail- ures exist, two questions still must be addressed before one should conclude that gov- ernment regulation will help. First, can government resolve the problem at a cost lower than that of the inefficiency caused by the market failure? Government intervention is
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Multinational Counterfeiting Counterfeit products used to be mostly pirated music CD-ROMs, cheap Rolex watches, and software. Today, virtually
all branded products compete with their counterfeit twin. In 2004 Brazilian police seized more than $1 million worth
of bogus Hewlett-Packard inkjet cartridges. The Chinese confiscated everything from counterfeit Buick windshields to
phony Viagra. Guam Secret Service uncovered bogus North Korean–made pharmaceuticals, cigarettes, and $100 bills.
General Motors is suing a Chinese carmaker for ripping off its Chevrolet Spark minicar. In 2003 Pfizer recalled some
16.5 million tablets of its cholesterol-lowering drug Lipitor after discovering they were fakes. The list goes on and on.
U.S. customs seizures of counterfeit goods have risen from under $50 million in 2000 to $140 million in 2004, and
experts estimate that less than 5 percent of total counterfeits entering the United States are intercepted.
Many counterfeiters are multinationals—diversifying their sourcing and manufacturing across borders. Investors
often include Middle East middlemen, local entrepreneurs, and even organized crime. The counterfeiters range from
fly-by-night operators to legitimate companies. Some are licensed producers of brand-name goods that produce an
extra, unauthorized batch. Others are former licensees who kept the designs or are generic manufacturers who
moonlight as makers of fakes. Five factories in China are licensed to make Yamaha motorcycles, but 50 plants have
produced bikes labeled “Yamaha.”
China, which produces nearly two-thirds of all pirated goods, is key to any solution. Chinese factories quickly copy
new products. “If you can make it, they can fake it,” says David Fernyhough, director of brand protection at
investigation firm Hill & Associates Ltd. in Hong Kong. But getting Chinese cooperation is tough. Chinese authorities
have ignored the problem because the victims were usually foreign brand owners. One pirate of fake windshields for
General Motors, DaimlerChrysler, and Mitsubishi Motors was fined just $97,000 and given a suspended sentence.
China gets tough on counterfeiters when Chinese are at risk. After 15 infants died from phony milk powder, the
counterfeiter was sentenced to eight years in prison. However, mounting international pressure is forcing China to
toughen its legal sanctions. Yet the big problem is too many counterfeiters have ties to local Chinese officials, and
counterfeit operations provide a major source of local employment.
Source: F. Balfour (2005), “Fakes!” BusinessWeek (February 7), 54–63.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 661
not free. Regulators must be hired and their regulations enforced. These actions con- sume real resources. To increase welfare, these total resources must be lower than the cost of the market failures eliminated. Second, will the regulators act in the public in- terest to resolve the market failure and not in their self-interest? Later in this chapter we examine this second question.
Externalities Government regulation can reduce market failures caused by externalities. Chapter 3 describes externalities as the costs or benefits created by the actions of one party im- posed on involuntary participants where the consequences of these actions are not regulated by the system of prices. Air pollution is an example of an externality. When you buy and consume gasoline, the purchase price compensates everyone in the supply chain from landowners to oil explorers, drillers, refiners, and gas station own- ers for providing that gallon. But the people who breathe the carbon monoxide produced when you use that gasoline are not compensated. The Coase Theorem states that resource allocations remain efficient, even in the presence of externalities, as long as property rights are clearly assigned and the transaction costs of enforcing and exchanging them are sufficiently low. Hence, government can reduce market
M A N A G E R I A L A P P L I C AT I O N S
Alternative Dispute Resolution To reduce the high cost of commercial litigation, many companies are turning to alternative dispute resolution (ADR)
mechanisms: Arbitration and mediation. Many commercial contracts now contain provisions binding the parties to use
ADR instead of litigation. Professional ADR firms providing such services streamline the dispute process by avoiding
lengthy court delays and more costly legal procedures.
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Frivolous Lawsuits In June 1994 Orange County, a California municipality, which defaulted on its debt payment because of losses from
trading interest-rate derivatives, received $400 million from Merrill Lynch in an out-of-court settlement. Merrill Lynch
was the investment bank that sold the derivatives to Orange County. The litigation alleged that Merrill should have
known that the county officials were trading inappropriately and, if so, it should have refused to do business with the
county. Merrill argued that county officials were sophisticated, acting in full public view. The precise duty a seller of
financial products owes to its customers is frustratingly vague, in part because this kind of case tends to be settled out of
court and thus no legal precedent is established. “There is nothing to stop a loss-making client’s imagination from
running wild over the settlement that threats might achieve.” Without a resolution of these legal uncertainties, bankers
simply cannot know their clients “too well.”
Orange County is an extreme example of the hindsight often employed by courts. As long as Orange County was not
losing money on its derivatives, there was no lawsuit. Courts enter and undo deals that go sour. Thus lawsuits are like
embedded options. If the product or service works, there’s no legal action. If the product or service fails, a lawsuit
results. Anticipating such lawsuits the seller of the product or service must price the option at the time of sale, so the
buyer must pay for this option. The market for the product or service collapses if the seller and buyer cannot agree on a
price for the product/service including the embedded option.
Source: “Orange County Seller Beware,” The Economist ( June 6, 1998), 75.
662 Part 4 Applications of Organizational Architecture
failures caused by externalities by defining property rights or by reducing the transaction costs of enforcing property rights.6
Consider the example of the federal government’s creating a market in pollution rights. In 1995, it set a cap on the number of tons of sulfur dioxide allowed into the air.7 Each year thereafter, the cap declines. The government issued to the 110 dirtiest power plants tradable certificates that matched their share of the cap. If companies cut their emissions below their caps, they could sell the excess to other companies that hadn’t made the necessary cuts. Companies can save certificates from year to year, but federal clean-air standards still limit pollution. Sulfur dioxide certificate trading amounted to about $3 billion in 2003.8 One company had to reduce emis- sions by 30,000 tons. It removed 20,000 tons cheaply by switching to low-sulfur coal. The remaining 10,000 tons could be removed only by spending $130 million on scrubbing equipment. Instead, it bought certificates for the remaining 10,000 tons, saving the company $100 million. This program, which reduced emissions 30 percent nationwide, is an example of the government’s reducing an externality using market-based mechanisms by defining and enforcing tradable property rights in pollutants.
The market for pollution rights works because firms whose costs to reduce pollu- tion are lower than the market price of the rights can sell their rights to firms that face higher costs of pollution abatement. Thus, society achieves the greatest reduction in pollution for the smallest aggregate cost. Moreover, there are an indefinite set of sul- fur dioxide producers whose sulfur dioxide production is already monitored; thus, the costs of enforcing these contracts are reasonably small.
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Direct and Indirect Costs of the Food and Drug Administration “The FDA ensures that the food we eat is safe and wholesome, that the cosmetics we use won’t harm us, and that
medicines, medical devices . . . are safe and effective.” To accomplish its mandate, the FDA has 9,000 employees and a
1999 budget of over $1 billion. Yet, the cost of protecting consumers from unsafe drugs includes more than just the
FDA’s $1 billion budget. Following FDA-mandated procedures, it can take 15 years to approve a new drug; in the
meantime, people who could have been helped are not. And despite all its efforts, the FDA process is not foolproof.
Many new drugs are pulled from the market because of some unforeseen problem. Duract was yanked after four patients
died and eight needed liver transplants. Pretrial tests cannot include all the possible drug interactions from other
medications. And doctors often prescribe drugs for conditions other than those for which the drugs were approved.
This example illustrates that regulation generates both direct costs and indirect costs. The indirect costs are
opportunity costs—drug therapies denied to potential patients because of delays in the approval process.
Sources: www.fda.gov/opacom/faqs/genfaqs.html; and A. Barrett (1998), “The Big Hole in the Drug Safety Net,” BusinessWeek ( July 6), 37.
6Note that some regulations establish and enforce property rights, but effectively make them nonmarketable
(inalienable). For example, the Occupational Safety and Health Administration is charged with enforcing
workplace safety regulations that specify an employee’s right to work in an environment that satisfies certain
conditions. Employees cannot waive these rights. Thus, even though an employee might be willing to bear a
risk for additional compensation that was lower than the cost of reducing the risk, such an employment
agreement is not allowed, and potential gains from trade are unexploited. 7J. Fialka (1997), “Breathing Easy,” The Wall Street Journal (October 3), A1; J. Fialka (1998), “EPA Plans Emission-Trading Program to Reduce Nitrogen-Oxide Pollution,” The Wall Street Journal (April 30), B11.
8www.epa.gov/airmarkets/trading.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 663
Public Goods Public goods are those commodities whose consumption by one person does not di- minish the amount available to others. Moreover, purchasers of a public good cannot exclude nonpurchasers. A classic example of a public good is national defense; de- fending you against foreign attack does not necessarily reduce the amount of protec- tion available to others. Moreover, it is difficult to exclude your neighbors from na- tional defense if they don’t pay their share. A lighthouse guiding ships at sea is a public good; one ship’s use of the lighthouse does not diminish another’s use of the lighthouse, and it is difficult to exclude nonpurchasers. An apple is a private good: Your consumption of an apple precludes others’ consumption of that apple. It often is difficult for a market to determine the appropriate quantity and price of a public good because free-riders are not excluded easily.
Total welfare would be maximized if quantity produced were set where the pub- lic good’s marginal cost equaled the sum of each consumer’s marginal value. For example, suppose a firm is considering launching a new satellite that will broadcast 500 channels. Aggregate welfare increases so long as the satellite’s cost is less than the sum of what each user would be willing to pay. Suppose there are 1 million po- tential users—half willing to pay $100 each ($50 million) and the other half willing to pay only $10 each ($5 million). If the cost of the satellite is less than $55 million, it is efficient to launch. But a competitive market might not reach this outcome if satellite transmissions are a public good. If the company tries to charge consumers for receiving the signals, all users might claim they only value the signal at $10, so the firm would collect only $10 million. Each user might try to free-ride. (Recall the incentive conflicts from free-riders involving joint ownership of assets described in Chapter 10.) Aware of this free-rider problem, the satellite firm will launch the satellite only if its cost is lower than $10 million. The problem is how to identify and charge the users who value the service at $100—a price above $10.
One solution to this free-rider problem is for the government to launch the satellite and pay for it with a tax. This is the basic rationale for using general taxes as the mech- anism to finance such government-supplied public goods as defense, police, and fire services. Note that this rationale presumes that the government somehow can estimate the consumers’ level of demand accurately. Yet, the government is not immune to par- ticular groups of consumers’ overstating their valuation in order to ensure that their de- sired project is completed. Moreover, the government will be lobbied by satellite mak- ers and others who will profit from this endeavor should the project be undertaken.
Besides having the government provide the public good, another possibility ex- ists: Convert the public good into a private good and exclude those potential cus- tomers with low valuations. For example, the company might scramble the satellite signals; those wishing to purchase the signal would have to rent a decoding box for something less than $100. Now, if the satellite costs plus the cost of the scrambling and decoding equipment is less than $50 million, a private firm will provide the ser- vice. But in this case, the potential gains from trade between the firm and the 500,000 customers who value the service at only $10 are lost.
Monopoly Chapter 6 describes how monopolies create resource misallocations. A monopolist sets prices above the competitive price (long-run marginal production cost) and output below the competitive output level. Some customers are willing to pay more than marginal cost, yet do not receive the product. Thus, not all gains from trade are exhausted. One potentially beneficial role of government is to limit the amount by
664 Part 4 Applications of Organizational Architecture
which the monopolist’s price exceeds marginal cost, and thus realizing more of the potential gains from trade. For example, state and federal regulators retain the au- thority to set or approve public utilities’ prices. However, performing this role well requires the regulator to know the utility’s true cost function.
In the United States, antitrust laws dating back to the 1890 Sherman Act give the federal government the power to limit the ability of these monopolies to set prices above competitive levels. The U.S. Justice Department and the Federal Trade Com- mission have broad powers to ensure the effectiveness of the market and protect competition by overseeing pricing practices, approving mergers, scrutinizing adver- tising, and regulating other business practices.
In determining whether a monopoly exists, the government must show that the alleged defendant has substantial market power to set prices above the competitive level. In most antitrust cases, the definition of the relevant market becomes a central focus of the lawsuit. In the Microsoft case the government argued that the relevant market that Microsoft controlled involves operating systems, and Microsoft has 90 per- cent of that market. Microsoft contends that the relevant market is for browsers and that in that market Microsoft’s Explorer does not have a dominant position.
Moreover, for this regulation to improve the overall resource allocation, regula- tors must operate in the public’s interest and not be “captured” by the utility or some other party. For example, some politicians think that Internet users should pay a tax to subsidize low-income individuals’ access to the Internet. These politicians argue that the poor deserve the same Internet access as the wealthy and that an Internet tax is a good way to achieve such an important social end. While this goal might be laudatory, such taxes are inefficient: They discourage Internet use whenever the tax exceeds the user’s marginal benefits. Moreover, some low-income individuals value receiving other goods and services more than they value a connection to the Internet.
It is somewhat ironic, given this array of efficiency issues raised by firms with market power, that many of the monopolized industries were created by various gov- ernment acts. For example, public utilities (such as electric companies, cable TV, or telephone companies) often are granted exclusive operating franchises to provide services within a specific geographic region.
Interstate Commerce Commission During the 1880s, midwestern farmers complained bitterly that rail rates were unfair; the sum of the costs to ship goods
from Chicago to Cleveland, Cleveland to Buffalo, and Buffalo to New York City was substantially greater than the cost
of shipping from Chicago to New York—the sum of the short-haul rates exceeded the long-haul rates. At this time,
railroads competed on long hauls but not on short hauls because there was usually just one railroad serving adjacent
cities such as Chicago and Cleveland, but several railroads serving more distant cities such as Chicago and New York.
(You could ship from Chicago to New York through Pittsburgh as well as Buffalo.) The federal government created the
ICC to regulate railroad freight rates. To ensure that the commissioners understood the industry they were to oversee,
railroad executives were appointed to the commission. The ICC “fixed” the rate disparities by raising the long-haul
rates and prohibiting price competition. When the trucking industry began competing with railroads for short hauls
(competition that would have eliminated the initial problem if the industry had been left unregulated), the ICC
expanded its scope to regulate the interstate trucking industry as well. Regulation raised interstate trucking rates where
trucks had been taking short-haul business from the railroads. The ICC provides an example of how regulators can be
“captured” by the industry they are regulating and end up protecting producers rather than consumers.
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Chapter 21 Understanding the Business Environment: The Economics of Regulation 665
Finally, some advocates of additional regulation implicitly presume that the gov- ernment can act with almost surgical precision, identifying and stopping inappropri- ate activities while leaving appropriate activities unaffected. Yet it is difficult to im- plement regulation perfectly. Even well-meaning regulators make mistakes. Recognizing that regulatory sanctions might be imposed on managers who are not behaving illegally (or inappropriately), these managers quite rationally might mod- ify their actions to reduce the likelihood that sanctions will be imposed. And such modified actions reduce the firm’s value to the extent that they are costly—perhaps because managers are diverted from actions that would have increased value.
Informational Failures Chapter 10 describes how adverse selection can lead to market failures. Adverse selec- tion refers to the situation in which an individual with private information that affects a potential trading partner’s benefits makes an offer, that is, detrimental to the trading partner. The classic example is the “lemons” problem—sellers of used cars generally know more about their mechanical condition than buyers.9 Thus, at any given price, sellers are more likely to offer “lemons” than high-quality cars. Suppose the average resale price of one-year-old Ford Broncos is $20,000. Used-car buyers do not expect vehicles offered will be in perfect mechanical condition. The $20,000 price thus reflects buyers’ forecasts of mechanical problems for one-year-old Broncos offered in the used-car market. For instance, Lena Cardone is the owner of a one-year-old Bronco with no mechanical problems. But if she cannot credibly convince a potential buyer that her Bronco has no problems and that she has another reason for selling, she must sell her Bronco for $20,000. Knowing that it is worth more than $20,000, Lena might prefer to keep it—some economists argue that a market failure results.10 Some state
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Cost of Regulation—Proprietary Information IRS officials now release portions of the “advance pricing” agreements they make with businesses. Through these
APAs, companies agree in advance with the IRS on how to set transfer prices for internal transactions among units.
Although the IRS says it removes sensitive details (taxpayer’s identity, trade secrets, and other confidential
information), some tax specialists worry. “Companies really bare their souls in filing for APAs,” says Timothy
McCormally of Tax Executives Institute. He says companies may skip the program rather than risk disclosure.
This is an example of the opportunity costs imposed by regulation. A firm can reduce expected legal costs by
negotiating an APA with the IRS. However, filing an APA can expose the firm to considerable risk by having some of
its most sensitive cost information outside its control in the hands of a government regulatory agency.
Source: “Tax Report,” The Wall Street Journal (February 3, 1999), A1.
9G. Akerlof (1970), “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84, 488–500.
10We believe that this argument requires care. It is true that if information were costless, unexploited gains from
trade would exist. But information is a good, one that is expensive to produce and transfer. Given the
distribution of information and technology for producing and transferring information, the allocation of
resources is efficient. We see little difference in arguing that “compared to a world where information costs
are lower, the current allocation of resources is inefficient” and that “compared to a world where the cost of
steel is lower, resources are misallocated.” Ultimately, efficiency must be judged given the costs implied by
available technology—not against a benchmark of zero costs. This is another example of the Nirvana fallacy
discussed in Chapter 17.
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governments have tried to limit this market failure by passing a “lemon law,” which requires used-car dealers to fix mechanical defects in used cars up to 30 days after the sale. (Note that although this law might raise retail prices of used cars by increasing the demand by buyers, it will not raise the wholesale price to sellers.)
The U.S. securities laws attempted to overcome alleged market failures that were blamed for the 1929 market crash. Here the information asymmetry involved in- vestors and corporate executives. Advocates for the securities acts claimed that in- vestors were fooled into buying overvalued securities because unscrupulous execu- tives did not disclose information about companies honestly. Of course investors have incentives to anticipate such behavior and only offer prices that reflect expected quality.11 The U.S. securities acts require such disclosures to reduce the asymmetry, thereby increasing the demand for securities.
Again, these laws are not costless. Regulators must be hired, and firms must expend real resources publishing financial results. Some of the mandated disclo- sures might involve proprietary information, that is, more valuable to competitors in crafting effective corporate strategies than to potential investors. And knowing that the information cannot be kept confidential, managers might be less likely to invest in its production. Moreover, external auditors must be hired to attest to the accuracy of the disclosures. Note that private solutions might be less costly than government regulation. Investors discount the price of securities unless the com- pany makes credible disclosures. Thus, firms face private incentives to provide in- formation for investors. Similarly, used-car buyers can hire auto inspectors or used-car sellers can certify that their preowned cars do not have mechanical de- fects and voluntarily provide warranties. Car buyers will pay more for used cars with warranties. In these cases, the contracting parties have incentives to overcome potential information asymmetries.
Redistributing Wealth
So far we have discussed two potentially beneficial roles of government: enforcing contracts to facilitate trade and eliminating market failures. In both roles the invisible hand of the free market can be improved (at least in principle) by government inter- vention. However, details of the implementation of policies to address these problems create opportunities for self-interested individuals to use this intervention as an op- portunity to enrich themselves. For example, national defense clearly is a valuable service provided by the government—one that addresses a potential market failure. But if an influential legislator can ensure that a defense contract is granted to a favored firm on lucrative terms, a large transfer of wealth results. Moreover, government must finance this intervention. It generally does so by levying taxes, but governments also raise revenue through user fees for toll roads, tariffs on imports, and licensing and reg- istration fees. In financing government intervention, there are additional opportunities to engineer wealth transfers. Throughout this book we employ the standard assumption that individuals operate in their own self-interest. This assumption also is useful in explaining how individuals behave when working for the government or in- teracting within the political process. For example, auditors have an incentive to lobby
11Moreover, for the price to be too high, it is not enough that some investors are misled (or even that the
average investor is unsophisticated and is misled); the marginal investor must be misled to affect prices. The
marginal investor—that investor who is just on the fence between buying and not buying, so that small
differences in price or information may change the decision to buy—is likely to be knowledgeable.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 667
for securities laws that increase the total demand for audited financial statements, especially if they can restrict entry into the auditing profession.
As an example of government effecting wealth transfers, consider taxi licensing that restricts the number of cabs. Figure 21.1 depicts the supply and demand curves for taxi rides in a perfectly competitive, unregulated market. Each cab owner charges price P* equal to average (and marginal) cost and hence (assuming identical suppliers) makes no economic profit. Absent government intervention, the price of a cab ride is P* and the number of cab rides is Q*. Suppose the gov- ernment—in the name of protecting the public from low-quality cabs—restricts the number of taxis and thus the number of cab rides to Q �. To operate a cab, the driver must display a taxi medallion, which are limited in number. The price of a taxi ride rises to P�, and the marginal cost per ride is P*. Consumer surplus falls by the shaded area. Profit per ride is P � � P*, and total industry profit is the rec- tangular area �. There are fewer taxi owners, but those expecting to be in business are willing to spend up to � lobbying the government to restrict the number of cabs. In the extreme case, this entire profit stream will be expended on lobbyists and political campaign contributions.12
Consumers should be willing to spend their forgone consumer surplus (the shaded area) lobbying to prevent restricting the number of cabs. Yet because of free-rider problems, it is difficult to raise this amount for an effective lobbying campaign. So long as the cab owners are easier to organize—there are fewer of them and their wealth implications are more concentrated—taxi regulation can be passed despite the fact that the forgone consumer surplus for the riders exceeds the surplus gained by the owners. The lobbying expenditures by the surviving cab owners and con- sumers yield no productive benefits to society. If the number of taxis is limited to, say, Q�, there is a wealth transfer from cab riders to taxi owners, lobbyists, politicians, and regulators. This example illustrates how government regulation can transfer wealth among various parties. The example also indicates that both con- sumers and producers have incentives to lobby.
Q
D
P *
Quantity of taxicab rides Q *
π S
$
P ri ce
( in
d o lla
rs )
PÄ
QÄ
Figure 21.1 Wealth Transfers via Government Quotas on the Number of Taxis
S and D are the supply and demand curves for taxicab rides. Absent government intervention, the price is P* and Q* is the equilibrium number of cab rides. If the government restricts the number of cabs and thus cab rides to Q�, the price of a ride increases to P�. Consumer surplus falls by the shaded area. Industry profit is the area �. Those cab owners expecting to survive should be willing to spend up to �, lobbying government to restrict the number of taxis.
12Note that profit � is a flow. Thus, the taxi owners should be willing to spend up to the present value of the
incremental profit stream on lobbying activities.
Other examples of wealth transfers exist. Taxes are among the most obvious. Import quotas and tariffs transfer wealth from domestic consumers to domestic producers. Import quotas also help foreign producers act as a cartel. Licensing of doctors, dentists, and lawyers restricts entry into these professions and transfers wealth from the consumers of these services to the incumbent members of the professions. Although zoning restrictions can address externalities, thereby raising land values, they also transfer wealth. These wealth transfers generally are from the initial landowners whose property is restricted to those landowners whose land has no restrictions (or land where the restrictions are not expected to be binding). Subsequent owners of the restricted-use land buy the land at lower prices that re- flect the value of the restrictions. Government farm supports, which pay farmers not to grow certain crops, transfer wealth from consumers to the producers when the subsidy is created. (Again, subsequent purchasers of the farm land pay a higher price for the land as long as the subsidy is linked to the land.) Student financial aid, government support of university research, welfare, and Small Business Adminis- tration loans with below-market interest rates all involve wealth transfers.
Managers interested in understanding how government regulation affects the value of their firms must understand the inherent “market” for government regula- tion. There is both a demand for and a supply of government regulation. If they ignore this market, managers place themselves and their firms at risk. Most organi- zations find themselves at times lobbying for or against various proposed regula- tions at the local, state, federal, and even international levels. For example, General Motors argues for lower property assessments and local property taxes, fewer state environmental regulations, increased federal defense department procurement of its products, and more aggressive intervention by international trade organizations to help it gain better access to foreign consumer markets. In the next section we present an economic theory of this market for government regulation.
Economic Theory of Regulation Before presenting the theory of how the market for regulation works, we begin by first describing the underlying principles (demand, supply, self-interested politicians, and coalition formation).
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Regulated Limos in Las Vegas The Nevada State Transportation Services Authority (TSA) requires all limousine operators to have a certificate of
public convenience and necessity. One would-be limo owner describes the system like this: “The TSA regulatory system
is designed to protect large companies and to prevent entrepreneurs like me from competing.” To get a limo certificate,
applicants must show that “the granting of the certificate will not unreasonably and adversely affect other carriers
operating in the territory.” Existing certified limo companies can pose questions and raise objections that the applicant
must answer. One applicant filed 1,000 pages of information ranging from maintenance records to customer lists and
spent over $15,000 on the process. His application was denied. In 20 years, only three new certificates have been
granted. The area’s two largest firms (with 170 limos between them) have lodged objections to all new applicants.
The existing limo firms thus have used the TSA system to help limit entry, reduce competition, and maintain high
prices for limo services.
Source: R. Fitzgerald (1999), “Mugged by the Law,” Readers Digest ( January), 98–103.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 669
Demand for Regulation: Special Interests
Special interest groups are composed of self-interested individuals who, because of their current circumstances, stand to benefit from a proposed government legislation. The special interest group might be bicycle riders seeking a bike lane; they might be landowners, construction companies, and labor unions seeking a new federal highway project in their area; they might be milk farmers, organized labor, or the Sierra Club sponsoring legislation that furthers their causes. In most cases the de- manded legislation comes at the expense of some other group that either will pay for the legislation or will have their rights restricted by the legislation. The spe- cial interest group backing legislation to raise the sales tax collections to pay for a new sports stadium might consist of football fans, construction companies, skilled trades people, hotel and bar owners in the area, and sports reporters work- ing for the local media. A new stadium would make each of these individuals bet- ter off. People who are not sports fans are made worse off by the higher sales taxes. For most proposed government action, two special interest groups can be identified—those made better off and those made worse off.
Supply of Regulation: Politicians
Politicians, including members of the legislative and executive branches of gov- ernment, are the primary market participants who supply the regulations. They act as brokers among special interest groups favoring and opposing regulations. But more than just brokering these transactions, they often are active entrepreneurs in
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Special Interests and the Microsoft Antitrust Suit Only 19 of the 50 states joined the federal government suit alleging Microsoft violated the antitrust laws. It is
interesting to look at which states participated in the suit and the special interests located in the state. Microsoft’s major
competitors, Sun Microsystems and Netscape, are California-based companies; Novell is located within Utah. Both
California and Utah joined the suit. Washington, home of Microsoft, is not participating, neither is Texas. Texas
computer makers Dell, Compaq, and Tandy—who bundle Microsoft Windows into their machines—oppose the suit. It
appears as though politicians and regulators in the various states represent the interests of the computer firms in their
states when it comes to joining the federal government suit against Microsoft.
Source: C. Georges (1998), “Politics Play a Role in States’ Status in Microsoft Suit,” The Wall Street Journal (May 28), A24.
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Political Support U.S. Senator Trent Lott collected $850,000 from 144 individuals for his and other Republican representatives’
campaigns. The Wall Street Journal contacted these individuals and reported that “four out of five donors to the Lott [Political Action Committee] had identifiable stakes in specific programs and policies pending before government. One
shipping executive said, ‘I gave because I have an interest in how he votes on maritime issues. It’s self-interest.’”
Source: G. Hitt and P. Kuntz (1998), “The Money Trail,” The Wall Street Journal (May 28), A1.
proposing regulations and then helping mobilize special interest groups. Politi- cians must get elected and reelected. They do this by promising to pass (or defeat) legislation that helps (or harms) their constituents. This frequently involves proposing new legislation.
Economists assume that consumers, business owners, and managers are self- interested (Chapters 2 and 10); politicians are similarly motivated. Just because politicians claim that they are public-spirited does not make it so. As in private orga- nizations, agency problems exist within the government. Politicians’ activities are difficult to monitor. Simply promising to help deliver a particular regulation does not mean a politician will exert substantial effort to do so. It is difficult for voters to observe the level of effort exerted: Although politicians’ voting records are observ- able, their behind-the-scenes actions generally are not.
This view of public officials as self-interested individuals seeking to enrich them- selves by supplying legislation that benefits some group is based on numerous, care- fully executed studies of public choice.13 Our purpose here is to summarize the major managerially relevant insights from that research.
Incentives to Free-Ride and Form Coalitions The market for government regulation is a competition among those special interest groups supporting and opposing the regulation. The political power of a coalition de- pends on both its size and how well it is organized to deliver votes and political con- tributions relative to its opposition. For instance, opinion polls typically show that the majority of Americans favor stricter gun control. Yet the relatively small, but quite well-organized and well-financed, National Rifle Association regularly defeats most proposed firearm regulation. Although most Americans favor additional firearm regulation, they do not feel strongly enough to take the time and expend the resources to organize an effective coalition. They rationally choose to stay on the sidelines. This example illustrates several important points. Forming a politically ef- fective special interest group is costly. Its members must be kept informed of pend- ing legislation. They must be willing to write letters to politicians, to make campaign contributions, and ultimately to vote for those who support their position. Whether for emotional or financial reasons, people must feel strongly enough about the cause
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Regulators Exhibit Self-Interest in Microsoft Antitrust Suit The states’ suit against Microsoft is brought by the attorneys general (AGs) in each state. AGs are either elected or
appointed public officials. According to The Wall Street Journal,
[A] number of the AGs (the letters sometimes are said to stand for “aspiring governors”) involved in the suit are seeking higher office. [The Microsoft suit is] the type of case attorneys general dream about, regardless of how deeply it affects—or fails to directly affect—their states’ consumers or businesses. It’s a case filled with legal twists and turns, and high publicity. “We look forward to taking on big players,” says West Virginia Deputy Attorney General Jill Miles.
Thus, regulators (or at least attorneys general) are more than just passive representatives of their constituents’ interests.
Rather, they also have their own interests, which often include election to higher public offices.
Source: C. Georges (1998), “Politics Play a Role in States’ Status in Microsoft Suit,” The Wall Street Journal (May 28), A24.
13For a review of the material, see R. McCormick (1993), Managerial Economics (Prentice Hall: Englewood Cliffs), Chapter 15.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 671
to overcome their incentives to free-ride on the actions of others. Organizing an effective coalition involves many of the same organizational architecture issues described throughout this book—namely, creating incentives and monitoring devices to generate participation in the process.
For a coalition to be effective, the benefits of the government regulation each party in the coalition expects to receive must exceed the costs they bear in form- ing the coalition and lobbying. Consider a government import quota on foreign cars that raises the price of domestic cars $100. If consumers keep their cars an average of five years, they could save about $20 per year by effectively opposing such quotas. Yet these diffuse costs are generally too small to justify incurring the costs of forming a broad coalition, becoming informed of pending legislation, and acting on this information. Thus, most consumers rationally choose to remain uninformed. However, a $100 price hike on each car amounts to hundreds of millions of dollars for each domestic car company. These concentrated benefits are more than sufficient to justify the costs of forming and maintaining their coalition.
Market for Regulation14
To illustrate the market for regulation, consider an industry represented by the demand curve in the left panel of Figure 21.2. Marginal cost is constant at MC. If the industry is competitive and unregulated, the market price is Pc � MC. But if all the firms in the industry could collude and behave as a single monopolist, the price would be Pm— the monopoly price would be set where marginal cost and marginal revenue are equal. The right-hand panel of Figure 21.2 represents industry profit as a function of price.15
Maximum profit �m occurs when the price is set at the monopoly price Pm (assuming no price discrimination among customers). If the price is P0, nothing is sold and hence (with no fixed costs) profit is zero. Profit also is zero when the price is at the competi- tive level, Pc .
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Washington Lobbyists Harold Ickes, former White House deputy chief of staff to President Clinton, has become a lobbyist charging clients
anywhere from $10,000 to $20,000 a month. His clients include the American Federation of Teachers, the New York
City Council, Greater New York Hospital Association, and the Commonwealth of Puerto Rico. One client, the Coalition
for Asbestos Resolution, wants protection from huge worker-health claims. Another, American Crop Protection
Association that represents pesticide makers, worries that a new pesticide law passed in 1996 is so broad that the EPA is
going to run wild.
Ickes says, “I know a lot of people [in Washington] and how the place works. Business operates on paranoia. This
fear leads to a thirst for information—and with my contacts, I can supply it.”
Source: L. Walczak (1998), “Got a Problem? Dr. Ickes Is In,” BusinessWeek ( July 13), 106.
14This section draws on G. Stigler (1987), Theory of Price, fourth edition (Macmillan Publishing Company: New York), Chapter 20.
15Although we usually think of profit as a function of price, we plot price as the vertical axis to make
comparisons across the graphs easier.
In Figure 21.3 suppose an industry regulator, Ann Melville, is interested in maxi- mizing political support from her constituents—owners of the firms in the industry and the consumers of the industry’s output. Regulation gives her the right to set the price in this industry and thus to determine industry profits. Owners want high prof- its; consumers want low prices.
Figure 21.3 displays two curves that represent those combinations of prices and profits that yield equal political support in terms of campaign contributions and votes.16 For example, Ann is indifferent between setting price at Px and profit at �x and setting price at Py and profit at �y. Both combinations yield equivalent political support. At Px and �x she gets more support from consumers but less from producers.
672 Part 4 Applications of Organizational Architecture
MC
$$
Qm Qc πm
Pm
Pc
P0
Pm
Pc
P0
πQ
Quantity
DMR
Profit P
ri ce
( in
d o lla
rs )
Figure 21.2 Industry Profits in Competitive and Monopolized Markets
The left panel graphs industry demand and marginal cost. The unregulated competitive price is Pc and the monopoly price is Pm. The right panel represents industry profit as a function of price. Maximum profit �m occurs when the price is set at the monopoly price Pm.
Px
πx πy
Py
Pz PS1
PS2
Profit
$
P ri ce
( in
d o lla
rs )
Increasing political support
�
Figure 21.3 Political Support Functions
A PS curve graphs combinations of profit and price levels that produce equivalent political support from industry and consumers. Thus, the regulator is indifferent between setting price at Px and profit at �x and setting price at Py and profit at �y—both combinations yield equivalent levels of political support. However, the regulator prefers to be on PS2 than on PS1.
16Note that these curves are similar in concept to indifference curves in Chapter 2 and isoquants in Chapter 5.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 673
At Py and �y she gets less consumer support but more producer support. Ann prefers to be on political support curves that are lower and to the right—for instance, she prefers PS2 to PS1. On PS2, consumers have lower prices (and hence Ann gets more consumer support) for a given level of profit. For example, hold industry profits con- stant at �x ; if Ann is on PS2, consumers face a lower price Px than if Ann is on PS1 and consumers face a higher price Pz—Ann thus receives less consumer support. These political-support functions have positive slope. Higher prices reduce consumer sup- port that can be offset only with higher support from industry via higher profits. These curves are concave because at low prices, small price changes are little noticed by consumers. But at higher prices, they garner greater notice, thereby requiring larger industry profits to offset them. For example, when gasoline prices increased dramati- cally in 2005 following Hurricane Katrina’s production disruptions, politicians ap- peared on television supporting consumers and promising to investigate the high prices.
Although Ann prefers to be on a political support function as far to the right as possible, the actual political support function she can achieve depends on the trade- off between profits and prices as determined by specific conditions in the industry. Figure 21.4 combines the analysis in the earlier two figures. Given the profit-price profile in Figure 21.2, Ann is able to achieve political support PS2. Here she will set
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Cost of Protection: Automobile Import Restrictions In the 1980s, the U.S. and Japanese governments agreed on a “voluntary restriction” on Japanese cars imported into the
United States to protect American auto jobs. By limiting the number of cars imported, the price of Japanese cars rose
about $1,000, the price of European cars rose about $2,000, and the price of U.S. cars rose about $500. By one
estimate, the cost of saving one U.S. automotive job via this voluntary import restriction approached $200,000. Thus,
U.S. consumers paid about $200,000 per American auto job saved.
Source: E. Dinopoulos and M. Kreinin (1988), “Effects of the U.S.–Japan Auto VER on European Prices and on U.S. Welfare,” Review of Economics and Statistics 70, 484–491.
�
P *r
Pc
π*r πm
Pm
P0
PS1
PS2
Profit
$
P ri ce
( in
d o lla
rs )
Figure 21.4 Equilibrium Regulated Price
The regulator sets the regulated price P*r to be less than the monopoly price Pm, but more than the zero-profit competitive price Pc. At higher prices, the regulator loses more support from consumers than is gained from industry. At lower prices, the regulator loses more industry support than is gained from consumers.
the regulated price at P*r . Industry profits are �*r , which is less than maximum prof- its of �m. Ann favors a price between the monopoly and competitive prices. If she sets a higher price to generate more support from the industry, she loses support from consumers and finds herself on a lower political support curve. If she sets a lower price to garner more consumer support, she loses so much industry support that again she finds herself with lower overall political support.
Several important insights arise from this analysis:
• Regulators do not always behave in obviously consistent ways. They might re- duce monopoly prices but seek to form cartels in competitive industries where they can raise prices. Although appearing inconsistent, both types of regula- tion move price away from favoring entirely either consumers or producers.
• If consumers are unorganized, they offer regulators little political support rel- ative to an organized industry group. In the case of completely unorganized and ill-informed consumers, the political support function in Figure 21.4 be- comes vertical (at least over the relevant range) and the regulator maximizes support by setting the monopoly price. Conversely, if consumers are well or- ganized but industry owners are disorganized and offer no political support, the regulator faces a horizontal support function and will set the price at the competitive, zero-profit level.
• The outcome of the political process depends on the relative political support a special interest group can achieve. The more organized and the larger the special interest group, the more political support it can offer. Executives at- tempt to make the political support function steeper by increasing political contributions, organizing their employees to vote for the candidate, and reduc- ing consumer opposition through a public relations campaign.
• Government programs tend to benefit small groups (aerospace contractors) at the expense of large groups (taxpayers). Holding constant the total amount of wealth transferred, the larger the losing group, the smaller the average loss per loser. Similarly, the smaller the winning group, the larger the benefits per winner.
Deadweight Losses, Transaction Costs, and Wealth Transfers
Because special interest groups can enrich themselves at the expense of others, each group is willing to spend up to the amount they are expected to win or lose provid- ing political support. Recall from Figure 21.1—where government restricts the
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Brazil Deregulates Airfares “For decades, Brazil’s airlines competed only in the corridors of [the capital] Brasilia, where politicians dispensed
favors in return for free airline tickets and other goodies.” Airfares between Rio de Janeiro and São Paulo averaged
$500 (round trip). Deregulation has sparked intense competition. Fares on this route have fallen to about $200, and
Brazil’s largest airlines are currently complaining that they are losing money. This is an example of how regulators can
choose between prices and industry profits.
Source: P. Fritsch (1998), “Brazilian Carriers Plunge into First Fare War as Deregulation Ignites Ferocious Competition,” The Wall Street Journal (May 12), A15.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 675
supply of taxis, thereby driving up the cost of cab rides—that the lost consumer sur- plus (the shaded area) is a deadweight loss to society. The surviving cab owners are making a profit because now price is above their cost. But to limit the number of cabs, a government taxi licensing office must be created to issue permits. Police and courts must incur costs as they attempt to catch and punish unauthorized cab drivers. In addition to these costs, each side will incur costs of organizing, lobbying, and pro- viding political support for the politician. Minimizing these costs and deadweight losses is in both the winners’ and losers’ interests. Thus, government policies that generate smaller reductions in economic efficiency are more likely to be adopted be- cause the losers are harmed less and will oppose the regulations with less zeal, and winners will lobby harder since they have more to share.
Managerial Implications Having laid out the essential features of the market for regulation, in this section we describe the important managerial implications such as entry restrictions, forming coalitions, and business participation in the political process.
Restricting Entry and Limiting Substitutes
In Chapter 8 we describe how firms develop strategies that both create value and cap- ture value. Recall that it is not enough to build a better mousetrap; you must prevent others from copying your ideas and entering the market. We discussed patents, copy-
M A N A G E R I A L A P P L I C AT I O N S
Conservative Choices of Accounting Methods Large, highly visible firms like IBM, General Motors, and Microsoft tend to use more conservative accounting
procedures than smaller, less visible firms. For example, large firms are more likely to use depreciation methods that
write assets off faster, thereby lowering reported earnings. This evidence is consistent with these firms’ seeking to
reduce their political exposure by reporting lower accounting earnings. Since large accounting profits are often viewed
as measures of monopoly profits and hence attract more media attention, managers of firms subjected to these charges
attempt to blunt them by choosing income-decreasing accounting methods. This can reduce the amount of political
opposition these firms face.
Source: R. Watts and J. Zimmerman (1986), Positive Accounting Theory (Prentice Hall: Upper Saddle River).
M A N A G E R I A L A P P L I C AT I O N S
Why Do Ships Register in Liberia? Taking a cruise from Miami to the Caribbean? Why is the ship registered in Liberia? In fact most cruise lines register
their ships in Liberia. The answer is simple. If the ship is registered in the United States, it must be owned and crewed
by Americans, making it subject to U.S. labor laws, including the minimum wage. Liberia does not have such labor
laws and hence registering the ship in Liberia exempts it from U.S. laws, saving the ship’s owner a boatload of costs.
This is an example of how companies seek creative ways to reduce the costs of costly regulation.
Source: R. Tucker (2001), “Why Do Ships Register in Liberia?” Fortune ( June 11), 42.
rights, and trademarks as means to protect intellectual property. Now we examine how government regulations might be used to create additional barriers to entry.
The most direct way to restrict competition is a government regulation limiting entry. For example, labor union laws that prevent unionized firms from hiring nonunion employees raise wages in these firms. Immigration laws limit the numbers of foreign workers allowed into the country to protect the domestic labor force. It is ille- gal for private delivery services to deliver mail to a customer’s mailbox. Professions like law, medicine, accounting, and dentistry limit competition by setting professional licensing standards such as passing exams and requiring work-related experience. Pub- lic utilities such as telephone, gas, electric, and cable television companies have been granted exclusive franchises within specific geographic areas.
A less direct method of limiting competition is a government regulation that imposes a cost on certain competitors and potential entrants. For example, consider health codes that require restaurants to meet various regulations concerning the preparation and stor- age of food. Although such health codes increase all restaurants’ costs, they increase street vendors’ costs proportionately more than those of full-service restaurants. Thus, health codes restrict the number and types of street vendors and hence potential com- petition from new entrants. Or, recall Netscape’s involvement in the federal govern- ment’s antitrust suit against Microsoft. Microsoft argues that it was “set up” by Netscape in a June 1995 meeting where Netscape allegedly created a record that Microsoft proposed splitting the browser market with Netscape. Documents referring to this meeting were a key argument in the government’s case. In its settlement agree- ment with the Justice Department Microsoft agreed to disclose various technical data on software currently being developed so that other companies can write programs for Windows that compete with Microsoft products. This remedy reduces Microsoft’s competitive position and makes Netscape more competitive.
To illustrate how government regulation can change the relative competitiveness of firms, consider the market for rugs.17 Suppose there are two ways to produce the same rug. Labor-intensive firms employ 10 workers an hour at $15 per hour and use 30 pounds of wool at $5 per pound. It takes 1 hour to produce a rug at a total cost of $300 (10 � $15 � 30 � $5). Material-intensive firms also produce 1 rug per hour, also at a cost of $300, but they use 5 workers at $15 per hour and 45 pounds of wool at $5 per pound. Material-intensive firms cannot switch to become labor-intensive firms, and
676 Part 4 Applications of Organizational Architecture
M A N A G E R I A L A P P L I C AT I O N S
Restricting Entry into European Retailing “The fight against outlet malls will continue. If we allow one, the dam will break, and we’ll be swamped,” stated the
director of the German Retailers’ Association. U.S. and U.K. retailers are trying to enter European markets. To keep
them out, shops cannot stay open evenings and Sundays. Mall developers must contend with high wage rates, restrictive
zoning laws, and high property taxes. Public officials battle developers over signage and government permits. In Austria,
the chamber of commerce is lobbying hard to keep out foreign competitors. One retailer says, “Low prices will be our
downfall.” Thus, to limit the competition they face (especially from foreign firms), European retailers use a wide variety
of government regulations to restrict entry.
Source: E. Beck (1997), “Outlet Malls Make Headway in Europe Despite Opposition by Local Retailers,” The Wall Street Journal (September 17), A17.
17This example is based on R. McCormick (1993), Chapter 15.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 677
vice versa; moreover, firm sizes are fixed. The rug market is competitive and each rug sells for $300. There are only 200 labor-intensive firms and only 200 material-intensive firms. Total quantity produced and sold is 400 rugs per hour. In Figure 21.5 the market demand curve and the original supply curve intersect at a quantity of 400 rugs and a price of $300. Neither type of firm makes abnormal profits.
Now the material-intensive firms are able to get a $1 per employee per hour pay- roll tax implemented by the government. All firms are required to pay this tax. The total cost of a labor-intensive firm rises to $310 (10 � $16 � 30 � $5). The total cost of a material-intensive firm rises to $305 (5 � $16 � 45 � $5). The price of rugs rises to $310 because the demand curve intersects the new supply curve at a price of $310. The material-intensive firms are making abnormal profits of $5 per rug. The remaining labor-intensive firms are breaking even. But only 250 rugs per hour are produced. The result is that 150 labor-intensive firms go out of business. The 200 material-intensive firms continue to make abnormal profits of $5 per rug so long as they can prevent new material-intensive firms from entering.
This example illustrates an important managerial implication. A firm might ratio- nally support government regulations that impose costs on itself, as long as compet- ing firms incur higher costs. This drives the high-cost firms from the industry and allows remaining firms to earn economic profits because the marginal firm (or the next firm to enter) is a high-cost firm. Managers often support these regulations by arguing that they are in the public interest. For example, managers might argue the payroll tax is used to support social programs such as employee health benefits.
Other examples illustrate the pervasiveness of cost-increasing regulations that re- strict entry. General Motors lobbied for stringent miles-per-gallon standards in the early 1980s. Burlington Industries supported Occupational Safety and Health Admin- istration cotton dust standards for textile manufacturers. These standards imposed rel- atively higher costs on smaller plants, thereby allowing the larger plants to generate economic rents. Truckers support train safety regulation. Local merchants want tougher building codes. In the 1800s, English steam-powered mill owners argued for rules limiting child labor in factories. (This case is like that in Figure 21.5 where a payroll tax is imposed; it favors capital-intensive firms—steam-powered mills—at
D
Quantity of rugs
Q
S 1
S 0
$
300
305
310
250 400
P ri ce
( in
d o lla
rs )
Figure 21.5 Imposing a Payroll Tax Allows Low-Labor Firms to Earn Profits
Two hundred labor-intensive and 200 material- intensive firms are selling 400 rugs at $300 each. Imposing a payroll tax shifts the supply curve for all firms, but it shifts more for labor- intensive firms. The equilibrium price rises by $10, and the quantity falls to 250. One hundred and fifty labor-intensive firms exit the industry and each material-intensive firm earns economic profits of $5 per rug—so long as they can prevent new material-intensive firms from entering.
the expense of other labor-intensive firms.) Finally, large accounting firms supported regulations that required all CPAs to have extensive periodic peer review evaluations. These requirements impose relatively higher costs on smaller CPA firms, forcing them out of markets (such as those for publicly traded client firms) where large CPA firms dominate.
Forming Coalitions
The economic theory of regulation emphasizes the critical importance of coali- tion formation. Winning coalitions supply more political support to politicians (votes and campaign contributions) than losing coalitions. One way to increase political support is to expand the number of people supporting the regulation. This process sometimes produces unusual alliances. For instance, in the South during the early 1900s, illegal liquor producers (bootleggers) wanted to reduce competition from legal distillers. Bootleggers supported a coalition of church members who wanted to ban the sale of all alcohol. Responding to this lobbying, a number of counties in southern states became “dry” by passing legislation pro- hibiting the sale of alcoholic beverages. Since the bootleggers had been operating illegally for years and avoiding prosecution from federal alcohol tax collectors, continuing to operate their underground businesses posed relatively few new problems. This is a classic case of “politics make strange bedfellows” and has been called the “Bootleggers and Baptists Phenomenon.”18
We often observe a special interest group that lobbies to restrict entry because it furthers its economic interest (bootleggers) joining forces with a special interest group that lobbies to correct a social ailment (Southern Baptists). Another example is western coal producers supporting environmental groups who lobby for tighter air- quality emission standards that make burning high-sulfur eastern coal more expen- sive than their low-sulfur coal. Winning coalitions frequently contain industry groups, “public interest” groups, and regulators to produce a strong political force pitted against consumers and rival companies. For example, aerospace contractors to the space program form coalitions with science “buffs” to lobby Congress for more space funding.
678 Part 4 Applications of Organizational Architecture
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Steel Producers versus Steel Consumers In March 2002, the United States imposed a tariff on imported steel that increased the cost by as much as 30 percent.
American automakers and other steel-consuming industries complained that the tariffs have increased their costs, cut
their profits, delayed expansions, and caused them to lay off employees. However, since the tariffs, the U.S. steel
industry has invested more than $3 billion in streamlining their operations. On December 3, 2003, President Bush
rescinded the steel tariff. This is an example of how one industry—steel—used federal regulations to reduce
competition and impose costs on other domestic parties—steel consumers.
Source: E. Becker (2003), “U.S. Tariffs on Steel Are Illegal, World Trade Organization Says,” New York Times (November 11), A1; and J. Curl and J. Sparshott (2003), “Bush Rescinds Steel Tariffs,” Washington Times (December 5), Washingtontimes.com.
18McCormick (1993), 649.
Chapter 21 Understanding the Business Environment: The Economics of Regulation 679
Forming political coalitions is similar to forming coalitions within the firm to advocate new proposals. Members of a political coalition are usually risk-averse, and so new government regulations that are uncertain are more likely to be opposed. Ways of increasing the coalition’s support of a proposed regulation is to reduce the uncertainty in the regulation, emphasize a crisis, and organize a logroll.
On Business Participation in the Political Process
Some will question whether a firm should be an active participant in the political process. Certainly our analysis suggests that collectively, we would be better off if we could limit the government’s ability to pass regulation that restricts competition. In such a case, consumer prices would be lower and the deadweight costs and transaction costs associated with both lobbying for government regulations and enforcing the reg- ulations would be saved.
Yet in evaluating company participation, we believe several points are important to consider. First, managers have a fiduciary responsibility to maximize the value of
ANALYZING MANAGERIAL DECISIONS: Effect of the Microsoft Case on Other Computer Firms
One might expect that the government’s antitrust
actions against Microsoft would have affected the
values of other computer firms. In particular, direct
competitors such as Netscape and Sun should be
made better off, whereas firms selling complemen-
tary products such as Dell and Compaq would be
made worse off. A study of the stock price move-
ments of 159 computer-related firms surrounding
major news announcements of antitrust actions
against Microsoft from March 1991 to December
1997 yields some interesting findings. These 159
computer firms (excluding Microsoft) had a total
stock market value of $754 billion in December
1997. This group experienced an aggregate drop in
stock value of $35 billion on the three days
surrounding the 29 news announcements that
increased the antitrust enforcement against
Microsoft. Conversely, when antitrust news favorable
to Microsoft was announced, these firms’ value in-
creased $70 billion. Negative (positive) movements
of Microsoft stock at the time of antitrust enforce-
ment actions coincide with negative (positive) returns
for the industry. Notice that the 159 computer firms
include those firms supposedly wanting the
government antitrust suit to succeed. Surprisingly,
there is no evidence that individual firms such as
Netscape, Sun, Novell, or Apple realized higher
stock returns when antitrust actions were taken
against Microsoft. Repeated antitrust actions against
Microsoft have not increased the expected earnings
of other computer firms. “Surprisingly, government
action against Microsoft appears to inflict capital
losses on the computer sector as a whole. . . .
Withdrawals from policy enforcement have been
accompanied by positive shareholder returns
throughout the computer sector.”
Sun, Netscape, and Apple have encouraged the
government to pursue its antitrust suit against
Microsoft; California, where these firms are
headquartered, has joined the suit; yet Bittling-
mayer and Hazlett (2000) JFE find no evidence that these firms realize higher stock returns
when antitrust actions are taken against Mi-
crosoft. How might you explain these facts?
Source: G. Bittlingmayer and T. Hazlett (2000), “DOS Kapital: Has Antitrust Action against Microsoft Created Value in the Computer Industry?” Journal of Financial Economics 55, 329–359.
their firm—not to maximize social welfare. Regulation can have a material impact on a firm’s value. Second, companies did not create this system that allows these welfare- reducing regulations to be adopted—politicians did. Unfortunately, eliminating this wasteful activity seems unlikely. Far too much wealth is at stake. Too many vested interest groups (including politicians, regulators, lobbyists, and lawyers) exist to ex- pect that these very same people will adopt new laws reducing the demand for their services. Third, even if a firm decides not to pursue political activities designed to produce wealth transfers, it almost certainly will be confronted with trying to prevent regulation aimed at reducing its value. As Pericles (430 BC) noted, “Just because you do not take an interest in politics doesn’t mean that politics won’t take an interest in you.” Managers who avoid participation in the political process that would benefit their firms reduce shareholder wealth. This places their companies’ continued exis- tence at risk and calls into question their fiduciary responsibility to shareholders.
680 Part 4 Applications of Organizational Architecture
ANALYZING MANAGERIAL DECISIONS: World Motors
World Motors (WM) is a large U.S. automobile
manufacturing company. Eighty percent of its
plants and sales are in the United States. WM is
considering whether it should hire lobbyists to try
to influence a variety of pending legislation. There
are bills in Congress proposing to tighten automo-
bile emission standards as part of the clean air
laws, laws restricting union activity, increasing
worker safety rules, reducing the miles-per-gallon
standards on automobiles, and imposing import
quotas. WM supports legislation that increases its
firm’s value. Each piece of pending legislation is
evaluated using this criteria. The following briefly
describes each piece of pending legislation.
Emission Standards Tighter emission stan- dards increase the cost of cars because they require
more expensive emission-control devices such as
more precise fuel injection systems and catalytic
converters. One of WM’s major competitors has a
patent on a proprietary fuel emission system that
allows cars equipped with its technology to meet
the tighter emission standards. WM’s competitor
can install this proprietary technology on its cars
cheaper than WM can install its device required to
meet the higher emission standards.
Labor Union Laws Labor laws increase the bargaining power of unions and thus their ability to
extract higher pay or benefit concessions or provide
lower amounts of work. The pending legislation
proposes rules that make it harder for a local union
to call a labor strike.
Worker Safety Rules The Occupational Safety and Health Administration (OSHA) is proposing
that plants making metal castings (such as automo-
bile engine blocks) be equipped with air ventilation
systems that replace the air in the plant more
frequently than the current air-quality standard
requires. Most of WM’s engines are cast off shore,
whereas most of its competitors cast their engine
blocks in the United States.
Miles-per-Gallon Standards To conserve gaso- line, the federal government has mandated that au-
tomobiles produced by each company must comply
with a minimum miles-per-gallon standard. These
standards are met by producing lighter cars with
more efficient fuel systems. New rules requiring
tighter, more fuel-efficient vehicles are being pro-
posed. The mix of WM’s produced vehicles is very
similar to those of its major competitors in terms of
car sizes and their fuel efficiency. No auto company
has any proprietary technology to improve fuel
system efficiency.
Import Quotas Citing the unfavorable trade deficit, the U.S. government is considering regula-
tions limiting the number of foreign cars imported
into the United States.
1. For each piece of proposed legislation, should
WM support or oppose it?
2. Which pieces of legislation do you expect
WM’s local labor unions to oppose or
support?
Chapter 21 Understanding the Business Environment: The Economics of Regulation 681
Finally, it is important to evaluate carefully the strategic aspects of participation in the political process. Managers must consider carefully how government regulators and other affected parties will react to the manager’s lobbying activities. For exam- ple, managers must decide whether it is better to be a “first mover” or “second mover” in lobbying. Managers must ensure that their lobbying is “credible” in the sense that rivals change their beliefs because the manager has sufficient commitment to the strategy. And, managers must consider how their lobbying on the current gov- ernment regulation will affect repeated interactions in the future. Government regu- lation is another example of where game theory can help managers better understand and plan their actions.
Summary This chapter presented a framework for understanding how government regulation affects a firm’s strategy and hence the value of a firm. Chapter 8 and Figure 11.1 em- phasize that government regulation is a key environmental factor affecting a firm’s value. From changing the extent and nature of the competitiveness of markets, to reg- ulating labor and capital markets, to taxation, governments touch virtually all aspects of organizations. In this chapter we discuss the managerial importance of government regulation and the benefits and costs of this regulation, and present an economic theory of regulation. This theory helps managers to understand better how various regulations come about and how to participate in the markets for regulation more effectively.
Governments provide a system of laws and legal institutions that facilitate produc- tion and exchange; they also address various market failures. Legal institutions which define and enforce property rights lower transaction costs, thereby increasing both pro- ducer and consumer surplus. For example, the patent process increases the amount in- vested in research and development and ultimately the value of goods and services flowing from this R&D. Governments also seek to redress market failures such as ex- ternalities (air pollution), public goods (national defense), monopolies (antitrust laws), and informational failures (lemon laws).
It is important to realize that it is costly to enforce property rights and to resolve these market failures. To finance these beneficial functions, governments must raise revenues, usually through taxes. In the process of performing these functions and rais- ing the revenues to finance them, governments also can redistribute wealth, which im- poses costs on society. Government agencies, courts, and legislative processes must be financed out of taxes and fees. And besides the direct costs of operating govern- ments, there are potential indirect costs imposed on society associated with the wealth transfers that undoubtedly arise from most government actions. These wealth trans- fers are not merely zero sum games, in the sense that what one group receives another loses. Rather, there are transaction costs and deadweight losses (reduced consumer and producer surplus). In the process of transferring some of the pie from Peter to Paula, the pie is smaller because knowing that he might lose some of the pie to Paula, Peter has less incentive to make the pie as big as possible. Income taxes are another example. Paying, say, 30 percent of my income to the government in the form of in- come taxes causes me to engage in less work19 and consume more leisure.
The economic theory of regulation is based on those who demand regulation (spe- cial interests) and those who supply it (politicians). Special interest groups who are
19Suppose I am paid $20 per hour, H, and my utility function for work is $20H(1 � t) � 0.5H 2. I have disutility of work, that is quadratic. The tax rate on income is t. Taking the first derivative with respect to H and setting it equal to zero yields H * � 20 � 20t. If t � 0, I work 20 hours. If t � 50 percent, I work only 10 hours.
made better off by the regulation will lobby in its favor, whereas those harmed will lobby against it. Politicians are made better off by brokering these transactions. They generate political support in the form of campaign contributions and votes from the various coalitions formed to support or oppose the regulation. The size and political power of a coalition depend on both how well it is organized to deliver votes and political contributions as well as how poorly organized its opposition is. People must feel strongly enough about the cause for either emotional or financial reasons to over- come their incentives to free-ride on the actions of others. If consumers are unorga- nized, they offer regulators little political support relative to an organized industry group. The outcome of the political process depends on the relative political support a special interest group can achieve. The more organized and the larger the special inter- est group, the more political support it can offer the regulator.
This theory of regulation has several important managerial implications. To de- velop strategies that both create value and capture value—it is not enough to build a better mousetrap—you must limit entry by competitors. The most direct way to limit competition is a government regulation limiting entry (for instance, zoning laws or taxi medallions). A less direct method for limiting competition is a government reg- ulation that imposes a cost on certain competitors and potential entrants (for in- stance, health codes, worker safety standards, and pollution emission laws).
Another implication of the economic theory of regulation emphasizes the impor- tance of coalition formation. Effective coalitions supply political support to politi- cians (votes and campaign contributions). One way to increase political support is to expand the number of people supporting the regulation. Coalitions are like other types of organizations—they have organizational architectures. To make coalitions more effective within the political process, the coalition should be structured using the concepts of organizational architecture presented throughout this book. In par- ticular, incentives to participate and performance measures can be used to reduce free-rider problems within the coalition.
Finally, regulation can have a material impact on a firm’s value. Managers must decide whether or how to participate in the market for regulation. Remaining neutral does not guarantee that your firm’s value is unaffected. Managers who avoid partic- ipating place their company’s continued existence at risk and call into question their fiduciary responsibility to shareholders.
21–1. Proposed legislation would required 48-hour notification to all neighbors (within 150 feet of your property) for all pesticide applications that may be made to your property by trained,
professional applicators. This legislation is labeled “environmentally friendly.” Analyze the
impact to the environment. (Note that pesticides come in varying strengths with more toxic
products having a longer residual impact and thus requiring less frequent application.)
21–2. California (and other states) has passed laws that restrict the exercise of termination provi- sions in franchise agreements. Your boss says that he thinks this is a good idea—firms have
an incentive to terminate profitable franchises and replace them with company-owned out-
lets. He asks what you think.
Solutions to Self-Evaluation Problems 21–1. Pesticide Application Notification and the Environment
By raising the cost of a pesticide application, firms will be less likely to apply less toxic
products on an as needed basis, and more likely to use more toxic products on a “calendar
spray” basis. Pest management techniques that require monitoring and treating only when
Self-Evaluation Problems
682 Part 4 Applications of Organizational Architecture
Chapter 21 Understanding the Business Environment: The Economics of Regulation 683
and where needed (techniques generally hailed as environmentally friendly) will become
more expensive relative to traditional methods of blanket treating properties.
21–2. Franchise Termination Legislation
Both contracting parties voluntarily included termination agreements in franchise con-
tracts, presumably because they increased the value of the contract, net of the costs of the
clause. Franchisees pay less for franchises with these clauses because there is a chance
they would be terminated. Franchisers presumably were willing to receive less from the
franchisee when these clauses were included because it gave the franchiser flexibility to
change the ownership structure of the stores if future conditions warrant such changes. If
both parties to the contract are intelligent, rational parties, they “priced” such termination
clauses in the contract. Such clauses on net created value. The government passing laws
restricting such voluntary agreements reduces the value of new franchises. They result in
wealth transfers from the franchiser, who paid for these termination provisions in terms of
lower franchise fees, to the franchisee.
21–1. “When I bought this land, it was zoned only for farming. But the longer I live here, the more I resent the wealth transfer I’m paying to other landowners without such restric-
tions.” Comment.
21–2. Adam Smith often is quoted as saying, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the
public or in some contrivance to raise prices.” If Smith is right, does this justify a role for
government?
21–3. At a city council meeting, the Taxi Cab Owners Association argued for a fare increase. They note that the market price to buy or rent taxi medallions has been rising, and with
these higher costs, profitability is reduced. Evaluate this argument.
21–4. In 1997 Canadian 2 � 4 lumber studs with two holes drilled in them (so that electricians could run wires) were categorized by customs agents as Category #4418 and free of any tar-
iffs. If they had been categorized as #4407, they would have fallen under a quota system
whereby only the first 14.7 billion board-feet of lumber Canada imports to the United States
are duty free. The next 650 million are subject to a $50 export fee per 1,000 board-feet, and
beyond that, a $100 fee. Roughly 15 billion board-feet of lumber is imported to the United
States each year from Canada. If the Canadian 2 � 4 studs with holes are classified as #4407, this adds about $3,000 to the cost of a new home. Discuss the expected lobbying be-
havior of lawmakers from timber producing states (Montana and Alabama), the National
Association of Homebuilders, and U.S. lumber companies (for instance, Georgia Pacific).
21–5. What would be the impact of raising the federal minimum wage?
21–6. What are the benefits and costs of government regulation of air quality within cotton mills—for instance, specifying maximum levels of cotton dust (prolonged exposure leads
to “white lung” disease)?
21–7. What are the benefits of government regulation of air pollution from automobiles? What are the costs of this regulation?
21–8. Various politicians have proposed an Internet tax. One proposal would be to tax both out- going e-mail and every Web page downloaded. What groups are likely to support such a
tax and what groups would oppose it?
21–9. Dubliners often complain that there are too few pubs in their city. At night pubs can be quite crowded and prospective customers often are turned away. Some Dubliners blame
this pub “shortage” on the English who originally enacted laws restricting pubs centuries
ago when they ruled Ireland. Is it appropriate to blame the English? Explain.
21–10. Passing through Louisiana you notice billboards proclaiming “Louisiana’s shame—the only state that does not license chiropractors.” Who do you expect finances these
billboards? If licensing were adopted, who would be affected and how?
Review Questions
Ethics and Organizational Architecture*
chapter
22 C H A P T E R O U T L I N E
Ethics and Choices
Corporate Mission: Ethics and Policy Setting
Ethics
Value Maximization
Corporate Social Responsibility
Economists’ View of Social Responsibility
Corporate Policy Setting
Mechanisms for Encouraging Ethical Behavior
Contracting Costs: Ethics and Policy Implementation
Codes of Ethics
Altering Preferences
Education
Corporate Culture
Summary
I n December 1990, the head of Salomon Brothers’ government-bond trading desk, Paul W. Mozer, submitted bids for 35 percent of a 4-year Treasury note auction. He also submitted another $1 billion bid under the name of Warburg Asset Management—a Salomon Brothers
customer—but without the customer’s knowledge or consent. The two bids, which represented 46 percent of the issue, violated the Treasury’s auction rules that limited the amount sold to any single bidder to 35 percent of the issue.1 Mozer repeated this tactic at Treasury note auctions in February and April.
In April, Mozer became concerned that the Treasury was about to un- cover his illicit bidding tactics. He admitted his unauthorized bidding in the February auction at a meeting with Salomon Chairman John Gutfreund, President Thomas Strauss, Vice Chairman John Meriwether, and General Counsel Donald Feuerstein. They apparently accepted his confession to a one-time, not-to-be-repeated mistake and no immediate action was taken.
L E A R N I N G O B J E C T I V E S
1. Describe how corporate ethics and organizational architecture are linked. 2. Explain how, although it is over 2,500 years old, there is no universally accepted
theosophical consensus as to which behaviors are ethical.
3. Explain how monopolies and externalities provide a role for regulation—in these cases, private contracts and markets may lead to resource misallocation.
4. Understand how economists view social responsibility. 5. Describe how obtaining a diversity of input, legal standards, and business norms
help shape corporate policy choices.
6. Understand how market mechanisms like repeat sales, warranties, third-party monitors, disclosure, and ownership structure can encourage ethical behavior.
7. Discuss how the adoption of a code of ethics can increase firm value.
*Portions of this chapter were published in C. Smith (1992), “Economics and Ethics: The Case of
Salomon Brothers,” Journal of Applied Corporate Finance 5:2, 23–28; and J. Brickley, C. Smith, and J. Zimmerman (1994), “Ethics, Incentives, and Organizational Design,” Journal of Applied Corporate Finance 7:2, 20–30.
1In auctioning Treasury bonds, the U.S. Treasury awarded bonds first to the highest bidder at their
quoted prices, then they moved to the next-highest bidder. This process continued until the issue
was exhausted. If the Treasury received multiple bids at the price that exhausted the issue, it
allocated bonds in proportion to the bid size. But Treasury auction rules limited the amount of an
issue sold to any single bidder to no more than 35 percent of the issue.
Chapter 22 Ethics and Organizational Architecture 685
In May, he again employed this bidding tactic in another Treasury note auction. In June, the Securities and Exchange Commission and the Justice Department issued subpoenas to Salomon and some of its clients for records involving bond auctions. Salomon then initiated a review of its government-bond operations and in August disclosed its unauthorized bids over the period between December and May.
By May 1992, the government had imposed a number of penalties on Salomon Brothers. The Treasury barred Salomon from bidding in government securities auctions for customer accounts. While allowing Salomon to retain its designation as a primary dealer, the Federal Reserve Bank of New York suspended its authority to trade with the bank for two months. The firm agreed to pay $122 million to the Trea- sury for violating securities laws and $68 million for claims made by the Justice Department. It established a $100 million restitution fund for payments of private damage claims that might result from approximately 50 civil lawsuits that the firm still faced stemming from the scandal. Monies in this fund not paid to the plaintiffs reverted to the Treasury, not Salomon.
Although these legal and regulatory penalties were substantial, they represent but a fraction of the total costs borne by the firm. In the week that the information about the unauthorized bids was released, Salomon Brothers’ stock price dropped by one-third. This $1.5 billion fall in market value suggests that the market ex- pected Salomon to bear significant costs as a result of these actions. Further, the drop seems too large to reflect simply fines and other expected legal and regula- tory sanctions. In addition to the penalties and decline in the market value of Salomon’s stock, all of the senior officers who knew of the illicit bids, but failed to act swiftly, were forced to leave the firm—and none of these individuals has since worked in a major securities firm. Salomon was acquired by the Travelers Insurance Company in 1997 and, after Travelers merged with Citibank, became part of Citigroup. In 2002, Citigroup announced a major restructuring and would reduce the use of the Salomon name substantially. The case of Salomon Brothers illustrates that market forces can impose material sanctions on parties engaged in unethical behavior.
Over the past decade, much public attention has been devoted to the issues of business ethics and corporate social responsibility. Politicians and social critics have deplored materialism; the media have treated the public to sensational accounts of corporate scandal; and business schools across the country offer courses in ethics.
In recent years, many U.S. corporations have responded by issuing formal codes of conduct, appointing ethics officers, and offering employee training programs in ethics. Such codes and programs cover a wide range of behavior, but most emphasize the following:
• Compliance with laws and statutory regulations
• Honesty and integrity in dealings with customers and other employees
• Avoidance of conflicts of interest with the company
Although few would quarrel with such aims, equally few proponents of such corporate initiatives have bothered to ask questions like the following: Are such codes and programs likely to be effective in deterring unethical behavior by corpo- rate managers and employees? And, more pointedly, is the behavior enjoined by such codes consistent with the normal incentives of employees or managers, given the current organizational architecture of the firm?
686 Part 4 Applications of Organizational Architecture
Although it is recognized rarely in most public discussions of the subject, corporate ethics and organizational architecture are closely related. To increase the likelihood that individuals will behave ethically in their roles as managers and employees, corpo- rate performance-evaluation systems, reward systems, and assignments of decision rights can be designed to encourage such behavior.
In this chapter, we present five basic arguments: First, the term ethics is elusive. It has many different meanings, and these meanings
vary across cultures and over time. The term business ethics has been used to mean everything from corporate social responsibility to maximizing shareholder value.
Second, if the corporation is to survive in a competitive environment, it must maximize its value to its owners (primarily the stockholders). Taking care of other corporate stakeholders such as employees and local communities is important, but such care can be taken too far. If the firm reduces the owners’ value, this care can imperil corporate survival.
Third, a company’s reputation for ethical behavior, including its integrity in deal- ing with noninvestor stakeholders, is part of its brand-name capital; as such, this component of the firm’s value is reflected in the value of its securities. By the same token, individuals’ human capital—which determines their future earnings prospects—is based in no small part on their reputation for ethical behavior. In this sense, private markets provide important incentives for ethical behavior by imposing substantial costs on institutions and individuals that depart from accepted ethical standards. The Salomon Brothers trading scandal illustrates that the magnitude of these costs can be enormous.
Fourth, considerable emphasis in corporate ethics programs is on what we would argue are misplaced efforts to change employees’ preferences by attempting to persuade them to put the interests of the organization or its customers ahead of their own. Instead our approach, accepts people’s preferences and assumes they will follow their perceived self-interest. We focus on structuring the organization in ways that better align incentives of managers and employees with the corporate aim of maximizing value.
Fifth, even if ethical guidelines and training programs are unlikely to alter fundamental preferences, they nonetheless have the potential to add value by more explicitly communicating the firm’s expectations to its employees. However, to be most effective, such guidelines must be reinforced by formal aspects of the firm’s organizational architecture.
M A N A G E R I A L A P P L I C AT I O N S
Monitoring Employee Ethics Monitoring employee actions—including those with important ethical aspects—is a critical part of the organization’s
performance evaluation and control system. For example, the Transportation Security Administration launched a
crackdown on theft over the past two years. The TSA has been sending “bait bags” through airport screening containing
iPads, watches, and jewelry to entice dishonest agents. The program appears to be working; last year 56 screeners were
fired for theft and turned over to the police. This year, there have been 22 firings. Moreover, the number of complaints
filed against the TSA for handling property fell by 13 percent compared to the same period the year before. Catching
and dismissing dishonest agents who are caught has a direct impact on employee theft. But the more important
implication is likely to come from deterring theft by communicating the program’s existence and results.
Source: S. McCartney (2014) “New Tactics in the Fight Against Stolen Luggage,” The Wall Street Journal (August 14).
Chapter 22 Ethics and Organizational Architecture 687
Ethics and Choices People make choices. A cornerstone of this book is that individuals make choices to maximize their expected utility. Individuals have preferences over just about every- thing and choose how much to spend on food, transportation, housing, charitable contributions, and other purchases. People choose how to allot their time between work, leisure, and charitable activities as well as how to allocate their time among alternative leisure activities—for example, watching television, playing golf, or attending a symphony concert. Economics is the study of how people make choices; it is basically a descriptive study seeking to explain people’s observed decisions. In this book, our analysis has been descriptive, not normative. We have avoided suggesting what decisions people should make; we have not suggested that people should spend more time fund-raising for their local charities and less time watching television. We have argued that given people’s preferences, they will tend to select those activities that maximize their perceived well-being.
This chapter is also about choices—in particular, choices among actions that are perceived to have ethical implications. Much of the study of ethics specifically focuses on how people should make choices: It is the study of those behaviors people should pursue. In large part, ethics is normative, not descriptive. When philosophers speak of ethics, they are dealing with the millennia-old discipline that seeks to iden- tify those behaviors which are right or wrong, good or bad, virtue or vice. Moral philosophers have been debating ethics since ancient times, and all religions involve statements of which behaviors are ethical and which are unethical. All major reli- gions—Buddhism, Christianity, Confucianism, Hinduism, Islam, and Judaism— espouse the Golden Rule: “Do unto others as you would have them do unto you.”2
Western religions are based on the Ten Commandments, a code of ethical behavior. Behaviors such as lying, cheating, stealing, and killing are almost universally
viewed as wrong—except under mitigating circumstances (murder in self-defense is usually justifiable, for instance). However, certain behaviors viewed as wrong by some are viewed by others as right. For example, some people view abortion as wrong, whereas others view denying women the right to choose as wrong. Similar conflicts exist regarding birth control and a person’s right to die. In these cases, there
M A N A G E R I A L A P P L I C AT I O N S
GM’s Recall In 2001, GM engineers detected that the ignition switch used on their compact cars was faulty. An inquiry was opened
and a solution was offered. But apparently no action was taken until GM issued a recall in February 2014. By then, the
faulty switches had been installed in over 1 million cars. Moreover, these faulty switches have been linked to 12 deaths.
After the recall, GM CEO Mary Barra apologized for the delay, offered condolences to family members who lost loved
ones, initiated an internal probe by the Jenner & Block law firm, and appointed Jeff Boyer to the new position of vice
president of global vehicle safety. She charged him with handling all safety-related issues. Clarence Ditlow, head of the
Center for Auto Safety, said Ms. Barra’s appointment of a safety czar is a “big step in the right direction . . . the jury is
still out on whether there is going to be long-term change.”
Source: J. Bennett (2014) “General Motors Recalls 1.7 Million More Vehicles,” The Wall Street Journal (March 17); and J. Bennett (2014) “GM CEO Apologizes for Recall Delay, Vows Changes,” The Wall Street Journal (March 18).
2W. Shaw (1991), Business Ethics (Wadsworth Publishing: Belmont), 12.
688 Part 4 Applications of Organizational Architecture
simply is no universally accepted code of ethics on which one can rely to assess right and wrong.
Business ethics seeks to proscribe those behaviors in which businesses should not engage. Such actions range from the giving or taking of gifts, bribing government officials, misrepresenting data, discriminatory hiring practices, and boycotting third parties. For example, some deemed it unethical for a company to do business in South Africa while that country practiced apartheid.
Business ethics and organizational architecture are interdependent. Organiza- tional architecture, we have argued throughout this book, establishes incentives and thus affects the decisions managers and employees undertake. If it is impor- tant for businesspeople to behave ethically in their roles as managers and employees, it is important that the organization be structured to foster ethical behavior. In examining these issues, we first focus on external ethics policies controlling interaction between the firm and parties like customers, investors, and the local community. We then turn to internal ethics policies that deal with employees and managers.
M A N A G E R I A L A P P L I C AT I O N S
Martha Stewart Loses $275 Million Attempting to Save $80,000 On December 26, 2001, Martha Stewart sold 3,928 shares of biotech firm ImClone for about $60 a share, the day
before ImClone disclosed to the stock market that the FDA had rejected its cancer drug application. Federal authorities
claim that Martha Stewart had been tipped off by her friend, Samuel Waksal, CEO of ImClone, of the FDA decision
and that Stewart had illegally traded on inside information. Stewart denies the allegations. Martha Stewart’s investment
in ImClone on December 26 was worth about $240,000. In a little over a week, ImClone fell $20 a share. Had Martha
Stewart waited a week to sell her ImClone stock, she would have lost about $80,000. By selling on December 26,
2001, she saved about $80,000. But, at what cost? If Stewart knew she was trading on inside information, then she was
putting her reputation and the reputation of her firm, Martha Stewart Living, at substantial risk.
Stewart owned about 31 million shares of the publicly traded stock in Martha Stewart Living, where she is CEO. She
has over 90 percent of the voting rights in the company. In June 2002 stories broke in the press that Stewart and Waksal
of ImClone had ties and that Waksal was being investigated for insider trading of ImClone stock. Over the next two
months securities regulators began investigating Stewart for possible insider-trading violations. A shareholder in Martha
Stewart Living sued Stewart claiming she had a duty to investors to “maintain her good name and reputation and to
avoid situations that could negatively impact her name and reputation.” Shares in Martha Stewart Living fell from about
$17 per share at the beginning of June 2002 to about $8 a share in August, after the shareholder suit was filed and
Congress held public hearings where Stewart denied any wrongdoing. The 47 percent decline in Martha Stewart Living
compares to about a 10 percent decline in the market over the same period. This $9 per share fall wiped out about $280
million of Martha Stewart’s wealth. And this does not count any likely lawsuit settlements or legal fees she will pay.
Ethics is about choices. If Martha Stewart had any hint from Samuel Waksal that she was receiving insider
information about Waksal’s ImClone before she sold her stock, she should not have sold the stock. Trying to save some
or all of her $240,000 investment in ImClone affected Stewart’s reputation and a large portion of her 90 percent
ownership of Martha Stewart Living. Ms. Stewart appears to have made a bad decision on December 26, if she did in
fact trade based on a phone call from Sam Waksal. In 2003, Stewart was convicted of obstruction of justice and
securities fraud and served five months in jail, five months of house arrest, and two years' probation.
Source: http://money.cnn.com/2002/08/05/news/companies/martha_lawsuit/index.htm; http://money.cnn.com/2002/10/21/news/martha/;
Dow Jones News Service (2002), “Martha Stewart Down 12% on Concerns about Ex-Imclone CEO” (June 12); Martha Stewart
Living Omnimedia, Inc., Schedule 14A, Proxy Statement (April 3, 2002); http://biography.yourdictionary.com/articles/
why-did-martha-stewart-go-to-jail.html.
Chapter 22 Ethics and Organizational Architecture 689
Corporate Mission: Ethics and Policy Setting What is the mission of the corporation, and does it involve ethics? Most people have a pretty good idea about what they mean when they describe an individual as “ethi- cal.” Most of us feel an emotional allegiance to the Golden Rule that urges us to treat others as we would have them treat us, and we value qualities such as honesty, in- tegrity, fairness, and commitment to the task at hand. But what does it mean for a corporation to behave ethically? First, we have to understand what the term ethical means and then how it relates to the firm’s mission.
Ethics
Ethics is a branch of philosophy. Western ethical philosophy can be traced back at least 2,500 years to Socrates, Plato, and Aristotle. These ancient Greeks searched for a generally understood set of principles of human conduct. Their treatises revolve around the terms happiness and virtue. Writing in the thirteenth century, St. Thomas Aquinas “argues that the first principle of thought about conduct is that good is to be done and pursued and evil avoided.”3
There are numerous ethical theories, ranging from egoism (an act is correct if and only if it promotes the individual’s long-term interests)4 to utilitarianism (behaviors should “produce the greatest possible balance of good over bad for everyone affected by our action”).5 Kantian ethics judges the nature of the act, not the outcome; Kant argued that only good deeds matter.6 Adam Smith argued that through the invisible hand of market competition driven by self-interested traders, resources are directed to their most productive use and societal wealth is maximized. Ethical relativism holds “that moral principles cannot be valid for everybody; and . . . that people ought to follow the conventions of their own group.”7
Even a cursory review of the major ethical philosophies yields two immediate ob- servations. First, ethics is an enormous subject area that has engaged some of history’s best minds. Second, despite considerable effort, there is no universally accepted philosophical consensus across time and societies as to which behaviors are ethical and which are not.
Furthermore, when it comes to defining the ethics of organizations like public corporations that encompass large groups of people, there is bound to be confusion. A corporation, after all, is simply a collection of individuals—or, more precisely, a set of contracts that bind together individuals with different, often conflicting, inter- ests (see Chapter 10). In this sense, organizations themselves do not behave ethically or unethically—only individuals do. And if managers and employees are not pursu- ing their own interests, then whose interests are they serving? Their bosses’? The shareholders’? The board’s? And what if there are major conflicts among these various interests?
3J. Haldane (1991), “Medieval and Renaissance Ethics,” in P. Singer (Ed.), A Companion to Ethics (Basil Blackwell: Oxford), 135.
4K. Baier (1991), “Egoism,” in P. Singer (Ed.), A Companion to Ethics (Basil Blackwell: Cambridge), 197. 5W. Shaw (1991), Business Ethics, 49. 6W. Shaw (1991), 74. 7R. Brandt (1970), “Ethical Relativism,” in T. Donaldson and P. Werhane (Eds.), Ethical Issues in Business: A Philosophical Approach (Prentice Hall: Englewood Cliffs), 78.
690 Part 4 Applications of Organizational Architecture
Value Maximization
Economic Darwinism Maximizing the firm’s value is the mission most economists ascribe to managers. By maximizing the size of the pie, each party contracting with the firm can receive a larger slice—including shareholders, bondholders, managers, employees, cus- tomers, suppliers, charities, and local cultural institutions. If the firm faces competi- tion for both inputs and outputs, the prices the firm pays for its inputs and receives for its outputs will be driven to competitive levels, and the firm will not receive any abnormal profits. Economic Darwinism and survival were discussed in Chapter 1. Long-run survival in a competitive environment dictates that firms seek to produce products of a specified quality at the lowest possible cost. In the absence of barriers to entry, firms that survive in the long run are those that deliver products consumers want at the lowest cost. This means that managers must adopt policies that maximize the value of the firm—or, what amounts to the same thing, the net present value of future cash flows distributable to the firm’s investors. If managers follow other poli- cies that raise their costs, value-maximizing competitors enter, supply products at lower costs, and sell them at lower prices. Eventually, firms that deviate materially from value maximization will fail.
Role for Regulation There are two important cases where value maximization leads to predictable resource misallocation. First, if the firm has monopoly power, it will reduce output and set price above long-run marginal cost. Second, if there are externalities— if firms’ actions impose costs or benefits on uninvolved third parties— the firm has incentives to produce too much or too little of an item. For example,
M A N A G E R I A L A P P L I C AT I O N S
The Tragedy of the Space Commons In November 2013, the 1.2 ton GOCE satellite, launched by the European Space Agency to study the earth’s
gravitational field, reentered the earth’s atmosphere, burned up, and scattered debris across the southern Atlantic
Ocean. From the more than 7,000 spacecraft that have been launched since 1957, NASA estimates that there are over
20,000 pieces of space junk larger than a grapefruit and 500,000 larger than a dust speck. This might not sound like a
big deal until you realize that each piece travels at 17,000 miles per hour. The damage that can be caused at these
speeds was dramatized in the 2013 movie, Gravity. Although there are technical challenges to getting this mess cleaned up, organizing such an effort faces a major challenge, what economists call the tragedy of the commons. Individuals
acting rationally and independently can deplete shared resources like fishing zones to the detriment of the larger
population. Since no one owns the ocean, you can get “overfishing”; each boat captures the benefit of catching
additional fish while all the fishing boats share the costs associated with depleting the stock of fish. Similarly, here the
ultimate problem is that no one “owns” outer space and hence the incentives to use it carefully and keep it “clean” are
reduced. If the United States were to underwrite the costs of such a cleanup project, it would have to share the benefits
with the rest of the world. It is like the litter problem faced by most local parks; visitors frequently do not dispose of
trash as carefully as they would in their own homes. But litter is rarely observed at Disney World. Since the Walt
Disney Company owns this property, they hire an army of maintenance workers to keep their park virtually spotless.
Source: G. Hardin (1968) “The Tragedy of the Commons,” Science 162, 1243–1248; and B. Bremner and P. Robinson (2014) “Clean- ing Up the Final Frontier,” Bloomberg Businessweek (January 16).
Chapter 22 Ethics and Organizational Architecture 691
because no one has readily enforceable property rights to clean air, factories may produce too much air pollution. In both cases, one potential limiting factor in these problems is government regulation. Thus, if appropriate regulation con- strains any resource misallocation from monopolies or externalities, firms can focus on value maximization within the bounds of the regulation.8
Compensating Differentials Maximizing a firm’s value requires managers to assess all costs and benefits of proposed actions accurately. Suppose George Wilson, manager of DisposeCo, is considering entering the business of the disposal of hazardous wastes. Employees exposed to such hazards usually demand a compensating wage differential to offset the higher risks of illness from such work (see Chapter 14). Therefore, when evalu- ating whether to enter this business, George must include these compensating differentials in his estimated costs.
Pharmacies are facing a difficult situation regarding their pharmacists who are refusing to fill contraception and morning-after prescriptions because dispensing the medications violates their moral or religious beliefs. Pharmacists across the country face dismissal or other disciplinary action when refusing to dispense certain medica- tions. Walgreens, the nation’s largest pharmacy, put four Illinois pharmacists on unpaid leave, stating they violated state law requiring pharmacists to sell medica- tions approved by the U.S. Food and Drug Administration. Some pharmacies are allowing pharmacists who object to filling certain prescriptions to pass them to other pharmacists willing to dispense the pills.9 But this increases costs—either two pharmacists must be on duty all the time, or the consumer must wait to get the prescription (or go to another pharmacy). Pharmacies may have to pay higher wages to attract pharmacists willing to fill contraception and morning-after prescriptions. (Of course, this compensating differential is reduced by pharmacists who are pro choice and endorse family planning.) In such cases, the costs of business decisions that some view as unethical are higher because of these higher compensating differentials, employee disciplinary actions and turnover, and potentially adverse publicity associated with such decisions.
8There are a number of issues implied by this brief discussion. In general, within the government, individuals
are not always acting to maximize social welfare. Thus, even if appropriate regulation could reduce these
problems in principle, there is no assurance that regulations are adopted to do so. See Chapter 21 and
G. Stigler (1971), “The Theory of Economic Regulation,” Bell Journal of Economics 2, 3–21. 9R. Stein (2005), “Pharmacists’ Rights at Front of New Debate,” Washington Post (March 28), A1; and J. Suhr (2005), “Discipline of Pharmacists Spark Complaint,” The Associated Press (December 8).
M A N A G E R I A L A P P L I C AT I O N S
Coca-Cola’s View of Corporate Responsibility In the 1996 Coca-Cola annual report, CEO Roberto Goizueta wrote, “Governments are created to help meet civic
needs. Philanthropies are created to meet social needs. And companies are created to meet economic needs.” In 1997
four Atlanta-based philanthropies donated $220 million to local causes. These four foundations held Coke stock valued
at $7.6 billion.
Source: A. Ehrbar (1998), EVA The Real Key to Creating Wealth ( John Wiley & Sons, Inc.: New York), 18–19.
692 Part 4 Applications of Organizational Architecture
Corporate Social Responsibility
One source of confusion about the corporate mission is the concept of “corporate so- cial responsibility,” which often is used interchangeably with corporate ethics. In 1969, Ralph Nader along with several other lawyers launched their Project on Cor- porate Responsibility with the following statement:10
Today we announce an effort to develop a new kind of citizenship around an old kind of private government—the large corporation. It is an effort which rises from the shared concern of many citizens over the role of the corporation in American society and the uses of its complex powers. It is an effort which is dedicated toward developing a new constituency for the corporation that will harness these powers for the fulfillment of a broader spectrum of democratic values.
As Nader’s statement suggests, the goal of some advocates of corporate social re- sponsibility is nothing less than to change the objective function of the corporation. In
10J. Collins (1979), “Case Study—Campaign to Make General Motors Responsible,” in T. Donaldson and
P. Werhane (Eds.), Ethical Issues in Business (Prentice-Hall: Englewood Cliffs), 90.
M A N A G E R I A L A P P L I C AT I O N S
Taxes and Corporate Philanthropy One potential benefit to the owners of a firm from having the corporation donate to charities is a reduction in taxes paid
to the government. Assume that both the corporate and personal tax rate is 50 percent.* Suppose a corporation has
profits of $5,000 before taxes and distributes all its after-tax profits to the shareholders as dividends. The firm has four
equal shareholders who collectively wish to contribute $1,000 to a particular charity. If the firm makes the contribution,
it is deductible from corporate income before taxes. Thus, the corporation has $4,000 of taxable income ($5,000 �
$1,000), of which $2,000 is paid in taxes and $2,000 is paid to the owners who pay personal taxes on the dividends
they receive. After personal taxes, each shareholder has $250 ($2,000 � 4 � 50%).
Now suppose the shareholders donate $250 each to the charity and the corporation makes no contribution. The
firm has pretax profits of $5,000, pays taxes of $2,500 (50% of $5,000), and distributes $2,500 to shareholders. Each
shareholder receives $625 ($2,500 � 4) before personal taxes, makes the contribution ($250), and has taxable income
of $375 ($625 � $250). Each pays taxes of $187.50 and has after taxes $187.50 ($625 � $250 � $187.50). By having
the firm make the charitable contribution, each shareholder has $62.50 ($250 � $187.50) more than when the
shareholder makes the charitable contribution. When the firm makes the contribution, the gift shields $1,000 from
corporate taxation.
These tax reduction gains for corporate philanthropy are most compelling when all the shareholders agree on the
amount and nature of the donations. Gifts to charities not valued by some shareholders reduce these shareholders’
welfare. Unfortunately, corporate stakeholders are unlikely to agree about which charities should receive corporate
donations and how much each should receive. Customers, employees, or independent sales agents objecting to the
firm’s choice of charities may take their business or services elsewhere. Moreover, corporate managers do not have an
obvious comparative advantage in choosing which charities to support. If it is time-consuming for managers to sort
through charitable requests and make the selections, this is time that could have been spent on other activities that more
predictably increase the firm’s value. Thus, even with the tax advantage of corporate philanthropy, shareholders are not
necessarily better off by having the firm make charitable donations instead of doing it themselves.
* The Bush-era tax revisions lowered the tax rate on qualifying dividends to 15 percent. Although this adjustment makes the
calculations more complicated the basic result is unaffected.
Chapter 22 Ethics and Organizational Architecture 693
Nader’s view, the corporation should be transformed from a means of maximizing in- vestor wealth into a vehicle for using private wealth to redress social ills. The corpo- rate social responsibility movement seeks to make management responsible for up- holding “a broader spectrum of democratic values.” Corporate support for such values could take the form of philanthropic activities, the provision of subsidized goods and services to certain segments of the community, or the use of corporate resources on public projects such as education, environmental improvement, and crime prevention. If all firms in the marketplace face the same social requirements, then the survival of any given firm is less of an issue. However, if some firms are exempted from redress- ing social ills, others’ survival in a competitive environment is more in doubt.11
Economists’ View of Social Responsibility
The conflict between Nader’s and economists’ views of the corporation is perhaps not as pronounced as it might appear. Corporations intent on maximizing firm value generally find it in their interest to devote substantial resources to noninvestor stakeholders such as employees, customers, suppliers, and local communities. For example, a company with a large plant in an inner city might decide that investing corporate resources and personnel to improve area schools leads to better-trained job applicants, more productive employees, and lower-cost products. Giving money to the local university might benefit the firm by improving its R&D, increasing its access to top graduates, or enhancing cultural and educational opportunities for its employees. Improving the environment lowers the company’s legal exposure to damage claims and also might reduce its wage bill to the extent that a cleaner local environment lowers the cost of attracting and retaining employees.
Maximizing firm value means allocating corporate resources to all groups or inter- ests that affect the value of the firm—but only to the point where the incremental ben- efits from such expenditures at least equal their additional costs. Thus, value maxi- mization might require expending the firm’s resources on members of an important corporate constituency to improve the terms on which it contracts with the company, to maintain the firm’s reputation, or to reduce the threat of restrictive regulation.
11M. Jensen and W. Meckling (1978), “Can the Corporation Survive?” Financial Analysts Journal 34, 31–37.
ANALYZING MANAGERIAL DECISIONS: Wilmorite Mall Development
Wilmorite Corporation owned a large tract of land
and proposed erecting a large, modern enclosed shop-
ping mall south of town. The mall was opposed by
an environmental group that argued that the land had
areas with standing water that waterfowl used in their
spring and fall migrations. The challenges resulted in
a substantial delay in the development of the land;
more extensive environmental impact statements had
to be prepared and plans had to be redrawn.
1. Was this development ethical?
2. The largest contributor to the environmental
group happened to own Southtown Mall, an
older strip mall across the road from the
proposed new mall. Was his contribution to the
environmental group ethical?
694 Part 4 Applications of Organizational Architecture
Many managers are inclined to endorse Nobel Laureate Milton Friedman’s pre- scription that the social mission of the corporation is “to make as much money for its owners as possible while conforming to the basic rules of society.” As we have noted, some companies will find it in their shareholders’ interest to “invest” in social causes of various kinds, but corporate investments that systematically fail to provide ade- quate long-term returns to private investors are wealth transfers that end up reducing social as well as private wealth.
Absent tax benefits, it usually is more efficient for the corporation to focus on cre- ating wealth and to let its shareholders, employees, and customers choose the bene- ficiaries of their charitable contributions. By maximizing their shareholders’ (or owners’) wealth, corporations effectively enlarge the pool of individual (noncorpo- rate) resources available for charity.12
Milton Friedman’s View of Corporate Social Responsibility What does it mean to say that the corporate executive has a “social responsibility” in his capacity as businessman? If
this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers.
For example . . . that he is to make expenditures on reducing pollution beyond the amount that is in the best interests of
the corporation or that is required by law in order to contribute to the social objective of improving the environment . . .
[The problem in this case is that] the corporate executive would be spending someone else’s money for a general
social interest . . . [when] the stockholders or the customers or the employees could separately spend their own money
on the particular action if they wished to do so.
Source: M. Friedman (1970), “The Social Responsibility of Business Is to Increase Its Profits,” New York Times Magazine (September 13).
A C A D E M I C A P P L I C AT I O N S
M A N A G E R I A L A P P L I C AT I O N S
Do’s and Don’ts of Corporate Giving Philanthropic spending by U.S. corporations in 2001 was estimated to be $9 billion or 1.3 percent of pretax profits. Nell
Minow, at a corporate governance research group, argues, “Corporate charitable contributions should be seen as part of
the company’s marketing strategy. If they promote the company’s products or brand identity, then it’s fine. If the money
goes to the ballet so the CEO’s wife can be on the ballet board, or to the local university whose president happens to be
the chair of the company board’s compensation committee, not fine.” An increasing number of corporate charitable gifts
are coming under public scrutiny. Perhaps the most spectacular case involved Tyco International and its former
chairman, Dennis Kozlowski, who was indicted for federal racketeering, fraud, tax evasion, grand larceny, and misuse of
company funds. Tyco contends that a $2.5 million fund at Middlebury College was endowed with its money but named
for Kozlowski. But other situations are attracting attention. Part of Jacques Nasser’s retirement package as CEO of Ford
Motor included a commitment by Ford to endow a scholarship at the educational institution of Mr. Nasser’s choice.
Deborah Patterson, president of the Monsanto Fund, offers the advice that firms establish clear parameters for their
corporate giving including categories of gifts and the focus of their giving such as education, environment, medical
research, and so forth. The CEO can propose a gift, but if it doesn’t fall into the preestablished parameters, then the gift
is denied. Moreover, CEOs should make it very clear whether the gift is from them personally or from the corporation.
For example, Dick Jenerette was insistent that his giving was not confused with Equitable Insurance’s, when he was
CEO at Equitable.
Source: S. Strom (2002), “In Charity, Where Does a C.E.O. End and a Company Start?” New York Times (September 22), B1–B12.
12J. Brickley (1988), “Managerial Goals and the Court System: Some Economic Insights,” Canada–United States Law Journal 13, 79.
Chapter 22 Ethics and Organizational Architecture 695
People who advocate ever-larger corporate contributions to charities and social causes such as retraining displaced workers and environmental cleanup (without con- sideration of their own long-run profitability) are effectively calling for higher implicit taxes on corporations. If all companies are so taxed, the taxes are borne ultimately by shareholders in the form of lower returns to capital, by employees in the form of lower wages, and by customers in the form of higher prices. Thus, ironically, potential social consequences of such an increase in corporate social responsibility include lower rates of economic growth, lower corporate values, lower employment, and reduced charita- ble donations (if reductions in donations by individuals more than offset the increases in corporate giving).
Corporate Policy Setting
Once a corporation has determined its mission, implementing the mission requires a set of operating policies. Again, ethical issues arise. It is futile to think that one can reduce excruciatingly difficult corporate policy issues to simple, universally ap- plauded policy decisions. Consider questions like
• Should we use laboratory animals for product testing?
• Should we market infant formula in Central Africa?
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Drugmakers Help People—and Themselves Developing new prescription drugs is a quite costly proposition. It takes years to develop and test drugs before they are
approved, and many compounds must be examined to yield one federally approved medicine. Some drugs targeted at
esoteric diseases have limited markets. So to recoup their investment, drug companies must charge very high prices.
For example, in 2003 the U.S. Food and Drug Administration approved a drug for a rare genetic disease, MPS-VI, that
costs patients $300,000 a year. To cope with higher prescription drug costs, patients must pay higher insurance
premiums and co-pays (a fraction of the prescription’s cost). But some patients cannot afford their premiums and
co-pays that can amount in some cases to several thousand dollars a week. Instead of losing these sales, the drug
companies are making donations to charities that then give money to patients to pay their premiums and to make their
co-pays. Drug company money allows patients to keep their insurance, and keeps the insurance companies paying for
the high-priced medicines.
“It’s a win-win situation,” says Dana Kuhn, president of Patient Services, a charity that solicits donations from
drugmakers. “Patients are helped and companies are helped. They make a small contribution to help the patient and get
much more money back when the insurer pays for the drug.” In 2004 Patient Services raised $22 million, $17 million
from 12 drug companies, and helped 20,000 patients. Genzyme, which makes the drug Fabrazme, donated money to
Patient Services to cover the $5,400 per patient co-pay for Fabrazme. And this $5,400 donation brings in $185,000 per
patient per year for Genzyme. In 2005 Patient Services raised $30 million. And Patient Services is just one such charity
that collects donations from drug companies to help patients.
Besides making donations to charities to help keep patients insured, drugmakers also donate high-priced drugs to
uninsured patients. These programs allow pharmaceutical companies to charge high prices to invest in R&D, to recover
their enormous costs, and to provide a return to their shareholders—and helps patients make their insurance payments
and get their medicine. In effect, these corporate charity programs allow drug companies to engage in more effective
price discrimination (see Chapter 7). The drugmakers effectively charge different consumers different prices, based on
their income and willingness to pay.
Source: G. Anand (2005), “Drugmakers Help People—and Themselves,” The Wall Street Journal (December 1), A1.
696 Part 4 Applications of Organizational Architecture
• Should we do business with a company that employs child labor in its Asian textile factory?
• Should we adopt different procedures for handling and disposing of hazardous wastes in Latin American plants than we use in the United States?
• Should we pay “fees” to expedite paperwork for export permits to an African market?
• Should we tow our obsolete North Sea oil rig to deep water and sink it?
Because there is no widely embraced definition of ethical behavior, these problems require careful analysis in establishing appropriate corporate policy. In particular, managers should be careful to collect data for estimating the total cost and benefits of alternative actions, including costs of adverse publicity, tarnished reputation, and lost customers. Although we cannot solve the above problems, we can suggest steps to help craft an appropriate policy.
Diversity of Input In questions with potentially contentious ethical implications, it is particularly im- portant to obtain input from a broad cross section of potentially affected stakehold- ers in the firm. Here, diversity in perspective can be especially valuable in identify- ing potentially sensitive areas that require additional analysis prior to setting policy. Diversity in backgrounds can help the management team better assess the potential total costs of alternative policies.
Legal Standards It is important to understand the legal consequences of potential policy choices. The first, most obvious, question is—Is it legal? Yet this knowledge alone is gen- erally far from sufficient to frame policy. For example, after the United States bombed Libya in 1986, some U.S. banks faced a dilemma: The U.S. Federal Re- serve and the State Department required that Libyan funds in U.S. banks be frozen. But the Central Bank of Greece simultaneously announced that under Greek law, any Libyan funds on deposit in Greece must be available on demand.
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Happier Animals Help Corporate Profits Edmond Pajor, an animal behavior and welfare professor at Purdue University, gives pigs a choice. The pigs can use
their snouts either to get into a pen where they can socialize with other pigs, or they can stay in their own pens and eat
alone. “We want to know: How important is social contact and space? What do they like and need?” Professor Pajor’s
research and other’s like it are being financed by the big food companies like MacDonald’s, Burger King, KFC, and
Wendy’s because the research helps these companies devise new standards aimed at ensuring more humane treatment
of animals destined for their customers. Todd Duvick, a food analyst at Bank of America Securities says, “The whole
drumbeat in the U.S. for the last century has been to reduce the cost of food. Now people are paying attention to things
like how food is produced and how animals are treated.”
By sponsoring research directed at more humane treatment of animals that ultimately end up in their kitchens, the
large food companies are hoping to increase the demand for their products. This is an example of corporate
philanthropy that increases their bottom line.
Source: D. Barboza (2003), “Animal Welfare’s Unexpected Allies,” New York Times (June 25), A1.
Chapter 22 Ethics and Organizational Architecture 697
If Libya had funds on deposit in Citibank’s Athens branch and requested the funds, the bank would have to choose between violating U.S. law or Greek law. Or, consider potential consequences of hiring child labor in a textile mill in Pakistan, even if it is legal there; some customers might object because the practice would be illegal in the United States or Europe.
Moreover, illegality may not be the determining factor. For example, it is doubt- ful that Federal Express would adopt a policy of firing a driver who violates the law by receiving a parking ticket. Hence, it is important to understand what sanctions might be imposed if a law is violated.
Finally, laws are not constant over time. For instance, although the 1995 Congress rolled back certain environmental regulations, some firms appear reluctant to take ad- vantage of the entire range of newly allowed activities. They appear to be concerned that if the political pendulum swings back, they might face some future liability.
Business Norms In the business community, there are expectations in transactions that do not have the force of law but nonetheless represent expected behavior. These norms are rarely written down; knowledge of them accumulates primarily with experience. These issues can be especially important when entering a new market. For in- stance, when Lincoln Electric decided to expand into Japan, it encountered unex- pected difficulties in selling its products. Lincoln’s managers had failed to appre- ciate the strong preference accorded long-standing business partners by Japanese companies.
In special cases, these norms are codified. Adopting procedures developed by an external group to handle sensitive issues can be quite useful. For example, standards for using laboratory animals in product testing are established by the U.S. Department of Agriculture, the National Institutes of Health, and the Public Health Service. Most organizations that undertake animal research adhere to these standards. Nongovernmental groups also participate in this process. For in- stance, firms in the motion picture industry frequently voluntarily adopt standards developed by the American Society for the Prevention of Cruelty to Animals. By stating that you adhere to the ASPCA code, a film company may be able to deflect much criticism.
Food Fraud Nobel-prize winner Gary Becker examined the economics of crime. He argued that the incidence of crime in general
and fraud in particular would increase (1) the greater the benefits of fraud, (2) the lower the probability of the fraud
being detected, and (3) the smaller the expected consequences of being caught. Food fraud in Great Britain appears to
fit this model quite well. For example, British inspectors found 22 tons of long-grain rice being sold as pricier Basmati.
Trading Standards officers seized nearly 2,500 jars of sugar syrup labeled as honey. This type of crime appears to be
growing. In 2007, the British Food Standards Agency established a food fraud database. From 49 reports in 2007,
reports grew to 1,528 in 2013. Europol thinks that some crooks who once focused on drugs have switched to food.
Although the use of drugs apparently is falling in the United Kingdom, everyone consumes food. Moreover, few
resources are being devoted to detecting such fraud. And if caught, penalties for food fraud are substantially lower than
for smuggling drugs or guns.
Source: Anon (2014), “A la Cartel,” The Economist (March 15), 55.
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698 Part 4 Applications of Organizational Architecture
Press Standard Another useful device managers use in determining the ethical issues in setting cor- porate policies involves assessing the public’s likely reaction. Examples of compa- nies withdrawing support for Planned Parenthood due to protests and boycotts from “Right to Life” groups illustrate the often important interaction among ethics, public relations, and the media. Ethics consultants regularly counsel corporate managers to apply the press standard to help determine which behaviors are ethi- cal. This criteria suggests that to judge whether an action is ethical, you should ask yourself whether you would be comfortable reading about your decision on the front page of the newspaper or seeing it reported on television.13 Suggesting that a decision is a good idea but only if it is kept confidential is quite likely to be a mis- take. Remember, the business press is quite sophisticated. Counting on a question- able decision being overlooked or ignored might be characterized better as wishful thinking than thoughtful analysis. Therefore, when considering a difficult ethical decision, try writing a press release. If you are unwilling to distribute the release, then the decision is unlikely to be appropriate.
Using publication of your behavior as an ethical benchmark for judging a deci- sion highlights the linkage between ethical behavior and reputation. Below, we discuss market forces that create incentives for people and firms to behave ethically. The argument is that unethical behavior adversely affects reputation, and one way to assess a decision’s reputational effects is to ask how it would read in The Wall Street Journal or the Financial Times.
Mechanisms for Encouraging Ethical Behavior
Ethical lapses frequently are manifestations of conflicts of interest—incentive prob- lems. As stated earlier, in most market exchanges, parties to the contracts have in- centives to devise mechanisms to reduce contracting costs, thereby raising the prices
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Adam Smith on Merchant Reputation Of all the nations in Europe, the Dutch, the most commercial, are the most faithful to their word. The English are more
so than the Scotch, but much inferior to the Dutch, and in the remote parts of this country they [are] far less so than in
the commercial parts of it. This is not at all to be imputed to national character, as some pretend; there is no natural
reason why an Englishman or a Scotchman should not be as punctual in performing agreements as a Dutchman. It is
far more reducible to self-interest, that general principle which regulates the actions of every man, and which leads
men to act in a certain manner from view of advantage, and is as deeply implanted in an Englishman as a Dutchman.
A dealer is afraid of losing his character, and is scrupulous in observing every engagement. When a person makes
perhaps 20 contracts a day, he cannot gain so much by endeavoring to impose on his neighbors, as the very appearance
of a cheat would make him lose. When people seldom deal with one another, we find that they are somewhat disposed
to cheat, because they can gain more by a smart trick than they can lose by the injury that it does to the character.
Source: A. Smith (1896), Lectures on Justice, Police, Revenue, and Arms, E. Cannan (Ed.) (Clarendon Press: Oxford).
13Thomas Jefferson offered similar advice in a letter to Peter Carr: “Whenever you are to do a thing, though it
can never be known but to yourself, ask yourself how you would act were all the world looking at you, and
act accordingly.” T. Jefferson (1785), in N. Beilson (Ed.), Thomas Jefferson: His Life and Words (1986) (Peter Pauper Press: White Plains), 47.
Chapter 22 Ethics and Organizational Architecture 699
they receive for their products or services. For example, when taking their firms pub- lic for the first time, founders of companies normally retain large positions in the stock and voluntarily impose restrictions on their own future stock sales to help ensure that their interests are consistent with those of their new investors. Such arrangements effectively raise the price investors are willing to pay.
Likewise, external public auditors voluntarily prohibit themselves from owning stock in the companies they audit. By not owning any stock, auditors do not gain by withholding unfavorable financial information. This increases their independence from their clients, raises the value of the audit, and hence increases the price firms are willing to pay for it.
As we noted earlier, because reputational capital is an important determinant of future earnings, market forces provide incentives for firms and individuals to behave ethically. But the effectiveness of market forces in controlling conflicts of interest and enforcing contracts varies among different kinds of transactions. Among the most im- portant characteristics of such transactions are the difficulty of ascertaining product quality prior to purchase and the likelihood that the transaction will be repeated.
Take the case of a buyer purchasing a product. For products whose quality can be determined at low cost prior to purchase, markets readily solve this problem. If buyers can monitor quality cheaply, they will do so. For example, a buyer negotiating a purchase of gold for Tiffany & Co. can confidently and cheaply ascertain its quality by assay.
For some products, quality is virtually impossible to determine prior to purchase. For example, you can know the quality of an airplane ticket only after the plane has landed, it is parked at the gate, you have deplaned, and retrieved your luggage. Although sellers have incentives to cheat on quality when quality is expensive to measure, rational sellers will provide products of lower-than-promised quality only if the expected gains exceed the expected costs.
Repeat Sales One important constraint on such cheating is the potential for future sales.14 More- over, corporations with established market positions and valuable brand names face higher costs of cheating and hence are less likely to cheat than start-up firms. The
M A N A G E R I A L A P P L I C AT I O N S
Signaling Quality by External Monitoring—Rice Aircraft In 1991, Rice Aircraft Company became the first company in its industry to earn ISO 9002 accreditation, an
international standard for quality management. This was a significant, highly visible signal of change within the firm.
For in August 1989, Bruce J. Rice, CEO of Rice Aircraft, had pled guilty to fraud and was sentenced to four years in
prison. The Defense Department forbade its contractors to do business with the company for five years, and annual
sales fell from $15 million to $5 million. At this point, Paula DeLong Rice, Rice’s wife, took over and set out to save
the company by visibly and radically transforming it. She implemented a total quality initiative and provided classes in
statistical process control, time management, and communications for all the company’s employees.
Paula DeLong Rice’s strategy appears to have been quite effective. Profit margins increased from 12 percent in 1992 to
27 percent in 1993 without benefit of price increases, order cycle time was reduced by 50 percent, and on-time deliveries
increased 98 percent. Paula DeLong Rice, moreover, is now in great demand as a speaker on managing for quality.
Source: T. Pare (1994), “Rebuilding a Lost Reputation,” Fortune (May 20), 176.
14L. Telser (1980), “A Theory of Self-Enforcing Agreements,” Journal of Business 53, 27–44.
700 Part 4 Applications of Organizational Architecture
costs of cheating on quality also are higher if the information about such activities is more rapidly and widely distributed to potential future customers. For example, in markets like the diamond trade in New York, which is dominated by a close-knit community of Hasidic Jews, cheating on quality is extremely rare.15
Warranties Seller-provided product warranties are another mechanism to reduce the likelihood of cheating. Since sellers bear higher warranty costs if they cheat on quality, they have less incentive to cheat. Seller warranties will be most prevalent when product failures result from factors that are under the firm’s control (such as manufacturing tol- erances). In this case, warranties directly impose the cost of failure on the parties who have the most control over product quality or failure. However, when failures are due primarily to factors that are under the customers’ control (such as the way the product is used or maintained), the moral-hazard problem will be greater and warranties are less frequently employed as a quality-assurance mechanism.
Third-Party Monitors In some markets, specialized information services monitor the market, certify quality, and help ensure contract performance. For example, Consumer Reports evaluates products from toasters to automobiles, the Investment Dealer Digest details activities of investment bankers, and A.M. Best Company rates financial conditions of insurance companies. These third-party information sources lower the costs for potential customers to determine quality and so increase the expected costs of cheating.
In credit markets, specialized credit information services like Moody’s and Dun & Bradstreet perform both a monitoring and an information dissemination function. The existence of such intermediaries provides an opportunity for the firm to guaran- tee quality. For this reason, corporate issuers pay Moody’s to have their debt rated over the life of the bond issue. By issuing rated public debt, a firm lowers the cost to other potential corporate claimholders (including potential customers) of ascertain- ing the firm’s financial condition.16
Evidence on the Penalty from Fraud Researchers have examined the stock market’s reaction to announcements of fraud charges against corporations. They
specifically focus on cases where the damaged party does business with the accused firm—thus, they focus on frauds
alleged against customers, suppliers, employees, and investors (but not damages to third parties such as in pollution
dumping). The evidence suggests that in the days around the first announcement in The Wall Street Journal, the average fall in the firm’s stock price is 1.58 percent. Thus, press reports of alleged fraud are associated with statistically
significant and economically material losses in value. Moreover, these losses were much too large to be explained by
legal costs and fines.
Source: J. Karpoff and J. Lott (1993), “The Reputational Penalty Firms Bear from Committing Criminal Fraud,” Journal of Law & Economics XXXVI, 757–802.
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15Other examples of ethnic communities, like the Chinese in Singapore, support the view that choosing
trading partners from within one’s own ethnic community economizes on the costs of contracting. J. Landa
(1981), “A Theory of the Ethnically Homogeneous Middlemen Group: An Institutional Alternative to
Contract Law,” Journal of Legal Studies 10, 349–362. 16L. Wakeman (1983), “The Real Function of Bond Rating Agencies,” Chase Financial Quarterly 1, 18–26.
Chapter 22 Ethics and Organizational Architecture 701
Disclosure The required level of disclosure in markets can also be important in determining qual- ity. For example, a study of two wholesale used-car markets with different levels of required disclosure found higher prices in the market with more required disclosure.17
The ability to “precommit” to disclose information reduces the potential information disparity between buyer and seller thereby reducing the discount buyers apply to their demand prices. Also, eBay.com, the online auction website, encourages participants to write messages about their experiences with their partner in the transaction. This provides future participants with more information about the performance of a poten- tial trader (the accuracy of product descriptions, the timeliness of shipping) and thus enables them to have more confidence in their transactions. Moreover, by creating this feedback mechanism, eBay provides sellers with a means of developing a reputation. This improves the performance of auction participants.
Ownership Structure Incentives to provide high-quality products vary across ownership structures. Take the case of franchise companies such as fast-food and lawn-care firms. Such compa- nies typically franchise some units rather than own all their stores in order to take ad- vantage of the incentive benefits of decentralized ownership while retaining scale economies in advertising and brand-name promotion.
Yet outlets that have little repeat business create a special problem. The franchise owners of these stores have an incentive to cheat on quality because they can benefit from a steady stream of one-time sales while reducing the reputation of the entire or- ganization; this is another example of the standard free-rider problem. At these loca- tions, the central company is more likely to own the unit than to franchise it, in part because a salaried manager has fewer incentives to cheat on quality.18
Companies with large amounts of debt in their capital structure can face a sig- nificant probability of financial distress. Such firms are more likely to cheat on
17H. Grieve (1984), “Quality Certification in a ‘Lemons’ Market: An Empirical Test of Certification in
Wholesale Used-Car Auctions,” working paper, University of Rochester. 18One study finds that franchise companies in lines of business with more repeat sales at individual units (e.g.,
lawn-care and beauty shops) are likely to franchise a higher percentage of total units than franchise lines
with less repeat business (such as motels, car rental agencies, and restaurants). J. Brickley and F. Dark
(1987), “The Choice of Organizational Form: The Case of Franchising,” Journal of Financial Economics 18, 401–420.
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Alibaba Expels Resellers Alibaba Group Holding, the Chinese e-commerce company, is removing some listings from its online shopping sites
to attract more luxury brands. For example, Burberry PLC had been worried about discount Burberry products—some
of which are fake—on Alibaba’s online marketplaces. These sites accounted for 80 percent of China’s estimated
$300 billion in online shopping in 2013. But Burberry had authorized none of these vendors to sell its products.
Burberry was told that Alibaba would do its best to get those products off its sites if it would open its own shop on
Alibaba’s online mall. It opened a store on Alibaba’s Tmall in April 2014. Alibaba’s offer to crack down on
“gray-market” goods for brands that opened Tmall stores provides a powerful incentive for brands to join the site.
Their intervention can be quite effective. For example, nearly four dozen Tmall shops sold Estée Lauder beauty
products earlier in 2014. But around the time it opened its Tmall store in May, all third-party products had vanished.
Source: K. Chu and J. Chiu (2014), “To Woo Lux Brands, Alibaba Purges Resellers,” The Wall Street Journal (August 11).
702 Part 4 Applications of Organizational Architecture
quality than financially healthy firms because repeat sales are less likely. There- fore, some firms “bond” product quality by adopting conservative financial poli- cies. Since financial distress is more costly for firms that market products where quality is difficult to ascertain, such firms have incentives to adopt financing poli- cies that lead to a lower probability of financial distress—policies such as lower leverage, fewer leases, and more hedging.
Contracting Costs: Ethics and Policy Implementation In our examples of Enron (Chapter 1), Merrill Lynch (Chapter 2), and Salomon Broth- ers (Chapter 22), none of these firms had formal corporate strategies of engaging in unethical behavior. Rather, their ethical problems arose from ineffectively controlling the behavior of individuals granted particular decision rights within the firm. They are examples of incentive problems within firms. Chapter 10 described the general in- centive problem as the difficulty in making corporate managers and employees perform in ways consistent with the aims of the firm’s owners. In addressing these internal ethical issues, this section makes two key points: First, the incentive problem of shirking or of opportunistic actions by an employee often is labeled an ethical lapse; and second, if all employees reduced their opportunistic actions (behaved more ethically), contracting costs would be lower.
To review the incentive problems that can arise with performance evaluation and monitoring, take the simple case of Alice Brown’s hiring Olaf Kolzig to paint her house. Especially in performing tasks that are hard to monitor by inspection after the job is completed, such as surface preparation (sanding, scraping, and priming), Olaf has incentives to shirk—or, at least, to do a job that may not be as thorough as Alice might like. Of course, Olaf also will be prompted by other considerations to do a good job. It may be a matter of private conscience; that is, Olaf’s sense of self-worth might be tied up with the quality of the workmanship, and violating such a self-imposed standard would impose major “costs” in the form of a tarnished self-image. Or Olaf might be constrained by the desire to maintain his commercial reputation (and, though it might take some time for a poor job of surface preparation to show its ef- fects, quality eventually will reveal itself). As we noted earlier in this chapter, reputa- tion is an important contributor to the capitalized value of one’s expected future earnings.
But because the prompting of conscience and the desire to maintain a reputation are neither universal nor constant, it’s impossible for Alice to know the extent to which Olaf is bound by such considerations. Alice faces an information problem: When hiring Olaf, she does not know the kind of surface preparation she will get, nor will she be capable of ascertaining that until well after the job is done and the bill is paid.
To reduce her vulnerability in such circumstances of informational asymmetry, Alice likely will ask for a list of references (if Olaf has not already provided one). Such references should give Alice a better basis for assessing Olaf’s time horizon and the im- portance he attaches to reputation. Olaf also might offer, or Alice might insist on, a one-or-more-year warranty on the job. (As discussed above, such common practices as the use of warranties, third-party references, and credit checks can play an important role in reducing contracting costs in the business world.)
But despite such assurances, some uncertainties about Olaf’s level of perfor- mance remain. For example, will he be around to make good on the warranty if the paint peels in a year? Perhaps Olaf has heavy debts and is about to declare personal
Chapter 22 Ethics and Organizational Architecture 703
bankruptcy. Or perhaps the job he does for Alice will be Olaf’s last before he em- barks on a new career painting and family portraits.
As a consequence of the possibility of shirking and her own remaining uncer- tainty, Alice effectively reduces the price she is willing to pay. Or, to state the con- verse of this proposition, if there were some means for Olaf to provide Alice with complete assurance about his level of commitment, Alice would be willing to pay a higher price for the job.
Three points emerge from this simple example. First, let’s assume Alice were able to design a perfect contract; for the sake of argument, let’s say that Alice had a cam- era which enabled her to observe Olaf’s activity at random intervals (and Olaf knew she had it) and that Alice were able to structure a pay schedule based on the observed effort. Even if she were able to devise such a monitoring and reward system, it would clearly not pay her to do so. The cost to Alice of writing, of administering, and, most important, of monitoring compliance with such a contract would be substantial— perhaps even greater than the value of the painting job itself. Thus, as this simple illustration is meant to point out, in most cases it does not pay to attempt to eliminate all possible shirking; because of the costs of writing and monitoring compliance with contracts, it is efficient to leave some slack in the system. The optimal amount of shirking or opportunistic behavior by an agent is not zero.
Second, the expected level of opportunism or shirking—which, again, is greater than zero—is priced in the contract. Thus, the principals do not bear the full costs of opportunistic actions by their agents. Typically, at least some of these costs are shifted back to agents in the form of lower prices for their services or products.
Third, higher ethical standards among agents, whether corporate employees or participants in market exchanges, would lead (over time) to a reduction in the level of expected opportunistic behavior and hence a reduction in contracting costs. As a result, there would be more transactions (including more jobs created) and higher prices paid to agents by principals (including higher corporate wages). This would occur not only because of a reduction in the amount of shirking but also because the costs of writing and monitoring contracts would fall. Both principals and agents would be better off. Economist Jack Hirshleifer makes this last point: “Altruism economizes on the costs of policing and enforcing contracts.”19 In discussing eco- nomic development, one writer lists low business ethics as an important factor im- peding growth. During the late nineteenth century, such practices as confidence men
19J. Hirshleifer (1977), “Economics from a Biological Viewpoint,” Journal of Law and Economics 20, 28.
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A CEO’s View of Verbal Contracts Most of our products were custom-made. Customers called in their orders over the phone. The orders . . . generally
required delivery of goods within one or two days. It meant we would usually begin production before receiving a
confirming purchase order. (This was before faxes.) The customer’s word alone was enough. In my 20-year stint as
CEO, not once did a customer go back on it. Unusual? Not at all. Without such trust, business couldn’t be conducted.
Similar transactions happen every day. . . . [W]e learned there are two ways to go: An eye for an eye, or do unto others
what you would have them do unto you. In business, the latter philosophy is far more common, simply because it
makes things work better.
Source: H. Aaron (1994), “The Myth of the Heartless Businessman,” The Wall Street Journal (February 7), A14.
704 Part 4 Applications of Organizational Architecture
selling shares, bankruptcy with concealed assets, and squandering capital increased the difficulty of raising capital to finance new ventures such as the construction of the railroads.20
The retired CEO’s story in the accompanying box illustrates an important point about the economic consequences of ethics: Ethical standards within an organization— or within an economy—affect the resources devoted to ensuring contract compliance and, hence, help determine overall productivity. If everyone voluntarily were to re- duce opportunistic behavior (such as withholding important information about prod- uct quality), then resources devoted to monitoring and enforcing exchanges could be used in other, more productive pursuits.21
Codes of Ethics We view important aspects of the corporate ethics problem primarily as problems of controlling incentive problems. And generalizing from the above discussion, there are several potential ways to control them. One way to control incentive problems would be to get corporate managers and employees to voluntarily adopt higher, more stringent ethical standards. A second is to use contracts that better align the interests of managers and employees with those of shareholders. Examples of such contracts in corporations are executive or employee stock options, bonus plans, and profit-sharing arrangements (see Chapter 15). (Such contracts also will act to reinforce voluntary codes.) Both more cost-effective incentive contracts and higher ethical standards can be expected to lead to lower contracting costs, greater corporate efficiency, higher corporate values, and greater social welfare.
As mentioned earlier, many companies and most professions have written codes of conduct, and some companies also have educational programs dealing with ethics for their employees. Such codes and programs regularly emphasize the following:22
• Employees must obey the laws and observe statutory regulations.
• Customer relations in terms of the reputation and integrity of the company are of great importance.
• Employees must support the company’s policies when interacting with customers.
• Conflicts of interest between the company and the employee must be avoided.
• Confidential information gained in the course of business must not be used improperly.
• It is improper to conceal dishonesty or to protect others in their dishonesty.
• Advice to customers should be restricted to facts about which the employee is confident.
Why have corporations adopted such codes? The most cynical view is that a corporate code of ethics is nothing more than a document that helps the firm defend itself against allegations of illegal behavior. Sentencing guidelines issued by the U.S. Sentencing Commission in November 1991 strongly encourage corporations to establish and communicate compliance standards and procedures for employees and
20T. Cochran (1964), The Inner Revolution (Harper & Row: New York). 21E. Noreen (1988), “The Economics of Ethics: A New Perspective on Agency Theory,” Accounting,
Organizations and Society 13, 359–369. 22These codes are not unique to the United States. For example, similar codes are observed in Australian firms.
B. Kaye (1992), “Codes of Ethics in Australian Business,” Journal of Business Ethics 11, 857.
Chapter 22 Ethics and Organizational Architecture 705
other agents through training programs and publications. For example, when an individual is found guilty of wrongdoing, the organization also might be vulnerable to federal sanctions such as fines. These penalties can be reduced by more than 50 percent simply by demonstrating that the organization has a compliance program that meets the Sentencing Commission’s standards.23 A compliance program consists at least of a code of ethics and a training program. These federal sentencing guidelines thus have blurred the line between legal and ethical issues.
But corporate ethical codes, as we just have argued, also have the potential to perform the economically valuable function of reducing the costs of monitoring and enforcing contracts. To the extent that they reduce managerial and employee opportunism, better ethical standards enhance the organization’s reputation and hence increase sharehold- ers’ wealth.
The critical questions, however, are these: Are ethical codes effective in deterring unethical behavior? And if they are, how and why are they effective?
Altering Preferences
There are two basic ways to view the function of corporate codes of conduct in re- ducing opportunistic behavior. One way is by appealing directly to employees’ con- sciences, attempting to instill in them loyalty to the organization and its goals. An economist might describe this as an attempt to alter people’s “preferences.”
Now, there is undoubtedly some value to this approach. As we noted earlier, personal codes of conduct and the guilt one suffers in violating such codes undeniably are constraints on many people’s behavior. Individuals’ utility functions contain many non- pecuniary factors, including conscience and guilt. As the following statement by Nobel Laureate Kenneth Arrow suggests, subjective concepts like ethics and morality surely are consistent with the economist’s notion of rational self-interest:
Certainly one way of looking at ethics and morality . . . is that these principles are agreements, conscious or, in many cases, unconscious, to supply mutual benefits. . . . Societies in their evolution have developed implicit agreements to certain kinds of regard for others, agreements which are essential to the survival of the society or at least contribute greatly to the efficiency of its working. . . . The fact [that] we cannot mediate all our responsibilities to others through prices . . . makes it essential in the running of society that we have what might be called “conscience,” a feeling of responsibility for the effects of one’s actions on others.24
The problem in applying this logic to corporate management, however, is that such “agreements to supply mutual benefits to others” are likely to be too amorphous to serve as a practical guide to individual behavior in large public companies with dif- fuse stock ownership. If employees are understandably unmoved by serving an anonymous group of “wealthy” shareholders, then who precisely are “the others” whose interests their morality is intended to serve? And what should employees do in those cases, noted earlier, where there appear to be (at least short-run) conflicts between the interests of the corporation’s shareholders and those of its noninvestor constituencies? After all, as we have seen earlier, the effective management of scarce resources often means saying no to the requests or desires of some employees, cus- tomers, and local communities. Moreover, the entire situation is complicated by the fact
23N. Gilbert (1994), “1-800-ETHICS,” Financial World (August 16), 20–25. 24K. Arrow (1974), Limits of Organization (W.W. Norton: New York), 26–27.
706 Part 4 Applications of Organizational Architecture
that the fundamental goal of the corporation—making money for its owners—is viewed as immoral or unethical by many advocates of corporate ethics.
Given this confusion about, and even conflict between, some professed ethical ob- jectives and the goal of the corporation, we are skeptical about organizational at- tempts to instill conscience or a sense of guilt in their employees—that is, to alter employees’ preferences. To the extent that these corporate ethics programs are aimed at trying to bring about material changes in employees’ preferences, we are skeptical that they will succeed.
Consider the transfer-pricing problem faced by corporations with multiple divi- sions that buy and sell to one another. In Chapter 17, the firm value-maximizing so- lution to this problem was described as setting the transfer price to the buyer at the seller’s opportunity cost of producing one more unit. But let’s assume (as tends to be the case) that managers of the selling division have better information about their costs than the purchasing division’s managers.
In such a situation, to the extent that a manager’s compensation is based on divi- sional profits, the selling division’s managers have the incentive to set the transfer price substantially above opportunity cost. In such a case, managers’ pursuit of their own division’s profits and their own business will come at the expense of total firmwide profits (because the managers of the buying division will purchase fewer than the optimal number of units).
Now, if adoption of a code of ethics somehow were to succeed in inducing divi- sional managers to reveal their private information about costs, units within the firm would be transferred at opportunity cost, and the firm’s profits would be increased. But as long as division managers are being paid based on the profits of their own di- visions, they are unlikely to reveal their actual costs.
Most economists generally assume that individuals’ preferences are given and for the most part are difficult to alter. We thus suggest that managers, rather than at- tempting to alter preferences, should design the firm’s architecture to motivate their employees’ to take certain actions. For example, in the above case, senior manage- ment might attempt to find a means of giving the divisional managers some stake in the profitability of the division to which they “sell” the product. A common, though only partly effective, solution to this problem is to give divisional managers stock op- tions with payoffs tied to the overall value of the company in addition to bonuses for divisional performance.
Education
Even if corporate codes of ethics are unlikely to either change preferences or eradi- cate self-interest, such codes still can play a potentially important role in modifying behavior. Up to this point, we have assumed that corporate managers and employees know the “right thing” to do to promote the interests of the organization. But this as- sumption does not always hold. In many cases, managers’ and employees’ uncer- tainty about ethical standards—or how to live up to them in practice—may well be a greater corporate problem than their failure to work hard or to act in accordance with standards that are well established and clearly defined.
We earlier described the confusion about the corporate mission stemming from the aims and actions of the social responsibility movement. Another potential source of confusion resides in the variability of ethical standards. What might have been acceptable behavior 10 or 20 years ago may not be so today. Social changes such as those brought about by movements as disparate as civil rights and women’s
Chapter 22 Ethics and Organizational Architecture 707
rights, on the one hand, and corporate restructuring, on the other, clearly have altered conceptions of socially accepted behavior. Moreover, the progressive globalization of product markets and a more diverse workforce are increasingly forcing corporate employees to recognize and adapt to differences in national or regional cultural expectations.
Given this large and, in some ways, growing uncertainty about what constitutes ethical behavior within large organizations, corporate codes of ethics and training programs potentially play an important educational role by communicating cor- porate expectations to employees effectively and by demonstrating to them how certain kinds of behavior reduce the value of the firm. For example, misrepresen- tations of products and services to customers for short-term gain can be shown to reduce the value of the firm by hurting its reputation and thus lowering its brand- name capital. Moreover, in the process of globalizing and thus dealing with cus- tomers worldwide, companies might be forced to respond to the increasing cultural differences—or absence of shared expectations—among their managers and employees by providing more explicit communication of standards and expectations.
Besides issuing a clear set of rules governing employee relations with con- sumers, corporations also are likely to benefit from communicating guidelines for dealings among managers and employees within the firm. For example, many companies develop their executives by rotating them through a series of jobs. The resulting management turnover can undermine informal agreements among man- agers and employees. Explicit, corporatewide communication of expectations can reduce uncertainty about enforcing unwritten agreements and thereby increase in- ternal efficiency.
Virtually all professions—medicine, law, accounting—have professional ethics codes. Prospective candidates must pass entry exams that test their under- standing of these codes. Most professional codes contain detailed descriptions of behaviors that reduce the value of the profession’s services. For example, profes- sional accountants are prohibited by their code of ethics from serving on the board of directors of their client firms. Such memberships reduce the appearance of independence of the auditor when rendering an opinion on the client’s financial statements. If one accountant is caught not disclosing a known financial fraud,
M A N A G E R I A L A P P L I C AT I O N S
The Appearance of Impropriety at Citibank, Argentina A newspaper article reported that H. Richard Handley, the president of Citibank Argentina, had sold portions of
Citibank’s Argentine assets to some of his friends at “what now look like bargain prices.” Citicorp spokesmen
dismissed that talk as “Monday morning quarterbacking,” pointing out that, at the time of the first sales, there was an
equal chance that the value of Argentine investments would rise or fall thereafter.
It is not important whether the terms of this particular set of transactions were appropriate or not; they may well
have been deals that furthered important business interests of Citicorp in Argentina. What this case highlights, however,
are the costs associated with the potential for self-dealing by corporate managers and the importance of stating and enforcing policies for business dealings on less than an arm’s length basis. The structure of this deal has forced
Citibank to defend its actions to employees, investors, and regulators.
Source: Miami Herald (April 24, 1994).
708 Part 4 Applications of Organizational Architecture
ANALYZING MANAGERIAL DECISIONS: The Tylenol Tragedy and J&J’s Credo
Johnson & Johnson sells a diverse array of products,
including baby care, first aid and surgical products,
prescription drugs, and industrial products. It
operates in a decentralized fashion through 190 com-
panies in 175 countries. Each business unit has its
own focused mission. Some units employ thousands
of people, and others, as few as six. Each business
unit is organized around a given market and a given
set of customers. In 1943, General Robert Wood
Johnson, who led J&J in its metamorphosis from a
small family-owned business to a worldwide enter-
prise, articulated the company’s basic philosophy in
the J&J credo. It has the following basic elements:
• Our first responsibility is to our customers—
doctors, nurses, patients, and mothers—to sup-
ply high-quality services and products at rea-
sonable prices.
• We are responsible to our employees to re-
spect their dignity and job security in a safe
working environment; compensation must be
fair and adequate.
• We are responsible to our communities to
support education, good works, and charities
and bear our fair share of taxes.
• Our final responsibility is to our stockhold-
ers. To provide a sound profit, we must make
investments in R&D, new products, and facil-
ities. When we operate according to these
principles, the stockholders should realize a
fair return.
One manager described how the credo affects J&J managers:
All of our management is geared to profit on a day-to-day basis. That’s part of the business of being in business. But too often, in this and other businesses, people are inclined to think, “We’d better do this because if we don’t, it’s going to show up on the figures over the short term.” The credo allows them to say, “Wait a minute. I don’t have to do that. The management has told me that they’re really interested in the long term, and they’re interested in me operat- ing under this set of principles. So I won’t.”
In 1982, J&J was stunned when seven people
died in the Chicago area after taking Tylenol cap-
sules that had been adulterated with cyanide.
Tylenol (capsules and tablets), manufactured by
McNeil Consumer Products division, was one of
J&J’s most profitable businesses and accounted for
8 percent of J&J’s sales. Subsequent investigation
determined that tampering with the capsules oc-
curred outside of J&J’s facilities. McNeil’s operat-
ing managers took immediate action, withdrawing
all Tylenol capsules from the United States and re-
placing them with tablets (not involved in the tam-
pering). They stopped producing Tylenol capsules
and began redesigning the packaging to make the
capsules tamperproof. This redesign process took
several months. J&J’s profits fell by over $100 mil-
lion and its stock dropped from over $46 at the
time of the announcement of the first death to
below $39.
Press coverage of the unfolding tragedy was
extensive. In an interview, a McNeil executive was
asked whether employees would receive any remu-
neration during the time it would take to redesign the
packaging and reconfigure the production line.
Rather than simply state that no decision had been
made, he made the commitment that no employees
involved in producing Tylenol would be laid off over
this period. Similarly, a reporter probing the costs of
this packaging redesign asked an executive how
much this would increase Tylenol’s price. Although
the issue had not been discussed, he announced that
the product price would not be increased.
1. Explain how the credo helped guide the managers in the McNeil division.
2. Most discussions of J&J’s handling of this
tragedy have been laudatory, yet J&J’s stock
price fell by more than $7. Does this mean that
the stock market thinks J&J’s managers reacted
poorly?
3. Analyze the decision not to raise Tylenol
prices.
4. Discuss the advantages and disadvantages of
listing shareholders as fourth priority in J&J’s
credo, especially in light of the Tylenol tragedy.
Chapter 22 Ethics and Organizational Architecture 709
this reduces the value of other accountants’ audit opinions. Thus, professions, like firms, have incentives to monitor their members for ethical breaches. However, the accounting profession’s ethics code did not prevent the failure of Arthur Andersen arising from its involvement with Enron (see the Andersen case in Chapter 18). Moreover, Andersen’s collapse and the public outcry cast a pall over the accounting profession, which led to increased government regulation of the profession.
Corporate Culture
More generally, codes of conduct and training programs in ethics have the poten- tial to contribute to the building and maintaining of a value-based corporate cul- ture. Like corporate ethics, corporate culture is an ill-defined term, but it gener- ally encompasses such factors as the ways in which work and authority are organized within a company as well as organizational features such as customs, taboos, company slogans, heroes, and social rituals. For example, a slogan like that of Federal Express—“When it absolutely positively has to be there overnight”—helps communicate the message that employees are expected to focus on meeting delivery schedules and that this focus will be recognized and re- warded by the organization. Singling out role models or heroes for special awards is another way of communicating the values of the company. Similarly, social rit- uals such as training sessions and company parties can help disseminate informa- tion by increasing interaction among employees and encouraging discussion of ethical standards. Indeed, the process by which a code of ethics is produced and the training programs through which these standards are communicated are po- tentially as important as the code itself in developing and maintaining the desired corporate culture.
Nonetheless, to create the value-based or consumer-focused organization that many companies seek to become, these less tangible aspects of corporate culture must be reinforced by more tangible actions. That is, the more formal organizational systems that partition decision rights and evaluate and reward performance, as well as sanctions for unethical behavior, all must be internally consistent and designed to encourage firm value-increasing behavior.
5. Suppose the packaging redesign and retooling
required a longer time period, extensive cost,
and that all Tylenol products were affected—
not just capsules. Might McNeil managers
have taken a different set of actions and how
might the credo have guided these decisions? 6. Despite the above indications of a strong
ethical culture within the company, a number
of civil and criminal actions have been insti-
tuted against J&J. In November 2013, a
massive $2.2 billion settlement was made to
resolve claims resulting from the promotion of
unapproved or off-label uses for three drugs
and alleged kickbacks to physicians and a
nursing home pharmacy distributor.
a. Discuss the impact of this settlement on J&Js market value.
b. These drugs were produced and distributed by Janssen Pharmaceuticals, a J&J sub-
sidiary. Discuss the potential implications
of having the drugs labelled as produced
and distributed by a business unit within
J&J versus by Janssen, a subsidiary of J&J,
versus Janssen with no mention of J&J.
710 Part 4 Applications of Organizational Architecture
Summary Business ethics is the study of those behaviors that businesspeople should or should not follow. This book is also about business behaviors, in particular, about how firms are organized to motivate and control the behavior of self-interested employees to maximize a firm’s value. The focus of this book has been primarily descriptive. Assuming that people are motivated by self-interest, how are they ex- pected to behave under alternative organizational architectures? Ethics is primar- ily normative: It is about how people should behave. Managers often endorse the ethical philosophy espoused by Adam Smith. In Smith’s view, through private ownership of property, self-interest, and competition, a society’s resources are put to the best use and produce the highest quantity and quality of goods and services at the lowest prices—value maximization.
Value maximization requires that all costs and benefits be considered. If a particular business decision conflicts with an employee’s or customer’s own per- sonal belief, that person is worse off. If enough people are affected, costs are imposed on the firm through compensating wage differentials, higher turnover, and forgone sales.
Moral philosophers and all religions have debated ethics since ancient times and yet we still do not have a universally accepted code of ethics. Witness the current debates over abortion or the use of animals for product testing. There is consider- able confusion about the meaning of corporate ethics. It appears unlikely that a universally accepted code of business conduct will emerge. The corporate social responsibility movement has focused less on raising corporate ethical standards than on transferring shareholders’ wealth to other parties such as customers, employees, local communities, charities, or cultural institutions. Although other corporate stakeholders are important, if the corporation is to survive, it must maximize its value to its owners—a goal that in turn promotes efficient use of scarce resources.
Many of the issues raised in this chapter are recurring themes in the popular press and are likely to continue to be in the future. You may be called on to resolve a sex- ual harassment case, an environmental issue, or a product recall dispute. There is no doubt that at least once during your career you will be faced with a key decision that some will label a major ethical dilemma. This chapter seeks to demonstrate that the same basic framework we presented in the earlier chapters can provide guidance for understanding issues involving ethics.
A number of important managerial implications are raised by the discussion in this chapter.
First, behaviors that others classify as unethical impose real costs on the firm by lowering the firm’s brand-name capital, especially when they are reported in the media. These costs from reduced reputation include forgone sales or higher costs because par- ties outside the firm are less willing to contract with the firm. Many ethical problems are similar to other incentive problems discussed throughout the text, and much of the same analysis of incentive problems can be used to analyze ethical problems.
Second, ethics has many different meanings, ranging from making firms socially responsible (transferring wealth from the firm to other parties) to trying to make em- ployees less self-interested. Another use of ethics means informing employees that certain behaviors impose large reputational costs on the firm, and hence the firm will impose sanctions on employees found engaging in such actions.
Third, mechanisms arise to constrain unethical behavior. Like contracting costs, costs of unethical behavior create incentives to minimize these costs. Managers
Chapter 22 Ethics and Organizational Architecture 711
should understand these mechanisms to ascertain under what conditions unethical behavior is most likely. For example, extra care should be exerted when structuring deals with firms in financial distress.
Fourth, decisions that have major ethical dimensions almost invariably involve potential adverse publicity and a decline in the firm’s brand-name capital. How the firm responds to the press affects how the public perceives the issue. In deal- ing with the media, the following application of our framework usually is helpful:
• News reporters are pursuing their own self-interest—not yours. They are try- ing to maximize their value, which usually means increasing their audience in order to sell more newspapers or TV and radio advertising. Reporters know more about their job than you do.
• Having access to the media is valuable. Developing brand-name capital is quite costly to do through advertising. Use your access to the media to present the firm’s position in a credible, honest way. Lying or misrepresenting the facts to the media is likely to backfire because reporters have the incentive and skills to uncover these misrepresentations—again, because such uncovered lies make juicy stories.
Fifth, ethics programs occasionally are used to try to alter people’s preferences. Senior managers concerned about the ethical conduct of their employees would do better to spend less time searching, like Diogenes, for “an honest man.” Rather, they should pay more attention to the incentives created by the firm’s organizational ar- chitecture (the three-legged stool). It is unlikely that Merrill Lynch would have faced widely reported consumer indignation and legal sanctions from inappropriate secu- rities recommendations had it anticipated the (quite predictable) incentives its com- pensation plan would give its employees. Incentives work. If the compensation plan pays employees for unethical behavior, then unethical behavior is exactly what the company will get. Our approach suggests recognizing the potential incentive prob- lems and then redesigning organizational architecture—not people’s preferences. Managers must structure their subordinates’ incentives to ensure that they do not re- duce the total value of the firm.
Sixth, ethical guidelines can highlight behaviors that increase, as well as behaviors that reduce, a firm’s value. Codes of conduct, rather than trying to change employees’ preferences, can communicate to employees those value-reducing actions that will not be tolerated and would lead to sanctions imposed on the employee, in addition to those value-increasing actions that are encouraged and would be rewarded.
T. Cochran (1964), The Inner Revolution (Harper & Row: New York).
T. Donaldson and P. Werhane (Eds.) (1999), Ethical Issues in Business: A Philosophical Approach, 6th edition (Prentice Hall: Englewood Cliffs).
M. Jensen and W. Meckling (1978), “Can the Corporation Survive?” Financial Analysts Journal 34, 31–37.
L. Nash (1991), “Ethics without the Sermon,” Harvard Business Review (November–December).
L. Newton and M. Ford (1998), Taking Sides: Clashing Views on Controversial Issues in Business Ethics, 5th edition (Dushkin/McGraw-Hill: Guilford).
E. Noreen (1988), “The Economics of Ethics: A New Perspective on Agency Theory,” Accounting, Organizations and Society 13, 359–369.
Suggested Readings
712 Part 4 Applications of Organizational Architecture
W. Shaw (1999), Business Ethics, 3rd edition (Wadsworth Publishing: Belmont).
W. Shaw and V. Barry (2000), Moral Issues in Business, 8th edition (Wadsworth Publishing: Belmont).
C. Smith (1992), “Economics and Ethics: The Case of Salomon Brothers,” Journal of Applied Corporate Finance 5:2, 23–28.
B. Toffler (1986), Tough Choices: Managers Talk Ethics (John Wiley & Sons: New York).
22–1. Seventh Generation of Colchester, Vermont, manufactures and markets “environmentally friendly” household products—vegetable-based, chlorine-free laundry products and nontoxic
cleaners. Seventh Generation used to sell its products through natural-food outlets and direct
mail catalogs. In 1992, the CEO of Seventh Generation, Jeffrey Hollander, concluded that to
continue to grow, his company had to appeal to a broader range of customers. The only way
to do this was to lower his prices. He concluded, “The research that says people will pay more
for socially responsible goods simply isn’t true.”
Hollander reformulated his products and compromised on environmental purity. Environ-
mentally harmful phosphates and chlorines were still excluded, but cheaper petroleum-
based cleaning agents were substituted. These changes allowed a dish detergent’s price to
be lowered from $3.50 to $2.50. While margins are lower, sales are up 20 percent. Also, the
new formulas work better.
Seventh Generation is criticized by some of its old customers for paying less attention to
core customers and substituting profits for idealism. Hollander says to his critics, “They not
only have greater access to our products, but also can get them cheaper.”
a. Do you agree with Hollander that people aren’t willing to pay more for socially respon- sible goods? Explain why or why not.
b. Is Seventh Generation behaving ethically by substituting petroleum-based cleaners into its products?
c. What additional information would you request to help Seventh Generation address its ethical questions?
Solutions to Self-Evaluation Problems 22–1. Seventh Generation and Product Formulation
a. Many consumers are not willing to pay more for environmentally safe products be- cause of the free-rider problem. Individuals pay the full cost of the more expensive
environmentally safe product but receive only a fraction of the benefits. Government
laws dictating product content supposedly control the externality of products pollut-
ing the environment. If some people want even lower levels of pollution, they can pay
for this by buying more expensive products. They “consume” the safer product’s envi-
ronment benefits by knowing they are using environmentally friendly products. But
they are not able to capture all the benefits.
b. Whether Mr. Hollander is behaving ethically depends on the definition of ethics em- ployed. In Adam Smith’s view, the legal pursuit of profits drive resources to their
most efficient use. Hence, given that perspective, Seventh Generation is behaving eth-
ically. If on the other hand, Seventh Generation developed a reputation for complete
product purity and is not informing its customers of the shift, then it is deceiving
them. (Note: We do not believe that there is a single right answer to this question, rather; we find this question useful to motivate an open discussion of the range of opinions on these issues.)
c. You would like to know what the marginal costs and marginal benefits of this decision are. That should depend on factors like:
• increase in quantity sold from the reduction in price (elasticity);
• reduction in demand from changing inputs, holding prices fixed (the shift in
demand);
Self-Evaluation Problems
Chapter 22 Ethics and Organizational Architecture 713
• reduction in demand for other of the firm’s products because of this change in policy;
• cost reduction from substitution of inputs; and
• potential cost reduction from similar substitutions in the firm’s other products.
22–1. Ben and Jerry’s Homemade Inc. has received much favorable press for its Rainforest Crunch ice cream. It uses official rain forest nuts and berries and all natural ingredients; it also sends
a percentage of profits to charities. However, another flavor, Cherry Garcia, contains sulfur
dioxide preservatives, and other flavors use margarine, not butter. What are the problems a
firm faces if it is “politically correct” in some products but not others?
22–2. The Body Shop has been widely noted for its ethical stands in its business: natural cosmet- ics, “Products for People Tested by People,” and First World wages for Third World prod-
ucts. Recently, Jon Entine published an analysis of the Body Shop in Business Ethics, alleg- ing false advertising and other ethical lapses. Would you expect such charges to have more
or less of an impact on a company like the Body Shop that touted its business ethics than if
the same charges were leveled against a competitor who made fewer claims?
22–3. The Body Shop started its business by developing an extensive network of franchisees. Recently, franchisees have complained about the company’s competing with their fran-
chises through direct catalog sales and over the Internet. How does an expansion of Internet
and direct catalog selling affect the Body Shop?
22–4. Eastman Kodak charged that the Fuji Corporation of Japan was illegally dumping film in U.S. markets. It asked the U.S. government to investigate and impose sanctions on Fuji for its un-
fair practices. But the world film market is dominated by Kodak and Fuji. If the government
agrees to sanction Fuji, Kodak will obtain significant market power in the U.S. film market. Is
it ethical for Kodak to attempt to use the government to undermine its competitor?
Review Questions
chapter
23 C H A P T E R O U T L I N E
Management Innovations
The Demand for Management Innovations
The Rise of TQM
Other Innovations
Why Management Innovations Often Fail
Marketing
Underestimating Costs of Change
Failure to Consider Other Legs of the Stool
Managing Changes in Organizational Architecture
Summary
H umana Hospital, a 555-bed institution in Dallas, Texas, funda- mentally reorganized the way it was structured for delivering care to its patients. Beginning in 1990, it applied a process called reengineering to develop patient-focused care, enhancing the de-
livery of health care and reducing costs.1
Hospital costs in the 1980s and early 1990s had increased faster than in- flation, thereby precipitating a health care crisis. The parties that paid for health care services—private individuals, employers, insurance companies, and the government—bore the higher expenses. To stem the rising health care costs, the government began reimbursing hospitals using a fixed fee for each procedure rather than paying for total costs incurred. And large em- ployers, through their insurance companies, began to pressure local health care providers by threatening to require that their employees be treated only at those hospitals and by those physicians that better controlled costs. As a result, hospitals initiated cost containment programs and began competing for patients.
Prior to reengineering, Humana employed the traditional hospital archi- tecture wherein patient care was provided primarily by functionally orga- nized individuals: physicians, nurses, and a score of specialists drawing blood samples and taking X rays and administering EKGs. Most large hospi- tals are organized around numerous, small, clinically focused nursing units with dedicated staffs and large centrally dispatched services—physical ther- apists, phlebotomists, and transporters, for instance. They have 60 to 100 de- partment heads and seven to nine layers of management between CEO and bedside caregiver. Patient care units generally are designed with excess ca- pacity; this enables them to handle all but the sickest patient with the most complex needs. Yet 60 to 80 percent of all medical procedures are for routine
Organizational Architecture and the Process of Management Innovation
L E A R N I N G O B J E C T I V E S
1. Explain why management innovation is a popular topic. 2. Discuss the demand for management innovation. 3. Discuss why management innovations often fail. 4. Identify the costs of changes associated with management innovations. 5. Explain the importance of sequencing organizational changes.
1Details of this example are from J. Lathrop (1991), “The Patient-Focused Hospital,” Healthcare Forum Journal (July–August), 17–20.
23-2 Part 4 Applications of Organizational Architecture
services (chest X rays, basic lab tests, EKGs). Therefore, infrastructure costs and idle time account for as much as 75 percent of costs for simple procedures. For example, in a typical 650-bed hospital only $.16 of each health care dollar spent reflects direct patient care. Scheduling, documentation, and idle time account for $.63 out of every dollar. The remaining $.21 covers occupancy costs, transportation, management, and supervision.
As a result of increased pressure to attract patients and control costs, some hospi- tals embraced process reengineering and the patient-focused care movement was born. Nursing roles were reevaluated and tasks reassigned. After the reorganization, patient care was delivered through teams, where two-person caregiver teams of nurses and technicians were responsible for most procedures performed on each patient.
The following characteristics describe a hospital with patient-focused care:2 At admission, each patient is assigned to a unit and given a standard protocol—some- times called a care map—which details the standard set of tests and procedures to be followed by the caregivers. Instead of documenting every procedure and test per- formed, the staff documents only exceptions to standard protocols. Exception-based charting reduces documentation by as much as 50 percent.
Each caregiver is trained to provide basic bedside nursing, basic X ray, respiratory care, EKGs, and the like. Routine care is provided by nurses, medical technicians, laboratory technicians, phlebotomists, and other staff working in the two-person teams assigned to patients. The team “owns” the patient: They admit the patient, doc- ument the care, serve the meals, change linen, and even clean the room after dis- charge. During a three-day stay, patients interact with an average of 15 employees in- stead of 55. Rather than being transported throughout the hospital for routine tests and waiting while they are performed, patients remain in their rooms for most tests.
Traditional hospitals are arranged by level of acuity and broad medical category. For example, cardiac intensive care units and orthopedic intensive care units are two separate acute care units specializing by medical category. Patient-focused care locates patients by the type of tests, therapies, and health care resources required. Wireless technology (pagers and cellular phones) allows more flexibility in how patients are grouped. Instead of a 15- to 20-bed dedicated unit, 50- to 100-bed patient centers allow more effective service lines to be developed.
Large centralized service bureaucracies are dismantled and their resources dis- bursed under the control of the patient centers. Each patient service center has satel- lite lab, radiology, and pharmacy units. The caregivers are cross-trained to perform many of the functions that formerly had been centralized. The extent to which decentralized satellites are efficient depends on the costs of the equipment. Basic X rays are decentralized, but CAT scans are not: Small inexpensive, simple-to-oper- ate X-ray machines are available whereas CAT scan equipment is still quite expen- sive and requires more specialized training to operate.
Advocates of patient-focused care emphasize that achieving these benefits requires a constellation of organizational changes. Unless the old hierarchy of spe- cialized departments is dismantled and replaced with a new structure with new reporting mechanisms and incentives, many of the benefits of patient-focused care will remain unrealized. That is, the elements of reorganization are complements— not substitutes.
2C. Schartner (1994), “Principles of Patient-Focused Care,” Journal of the Healthcare Information and Management Systems Society 7, 11–15.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-3
The kind of improvement our health care system requires cannot be obtained by isolat- ing a redesign initiative to any one of the patient-focused care principles. We need a more comprehensive effort that understands the complex interrelationships between the principles.3
This example of patient-focused care illustrates how one management innovation, reengineering, was applied within a specific hospital. Many organizations success- fully implemented reengineering programs. Others tried it with less success. Besides reengineering, other management innovations have come and gone. This chapter ex- amines the general topic of management innovations—why they are popular, why some succeed while others fail, and how managers implement changes in their orga- nizational architecture.
Management Innovations The titles currently displayed in the business section of any good bookstore present a seemingly endless array of management prescriptions: total quality management, reengineering, benchmarking, activity-based costing, just-in-time production, qual- ity circles, outsourcing, economic value added, balanced score cards, empowerment, self-directed teams, venturing, incentive compensation, cycle-time reduction, strate- gic alliances, 360-degree performance reviews, matrix organizations, downsizing, learning organizations, market-based management, core competencies, groupware, and so on. Given this cornucopia of management innovations, one might expect cor- porate executives’ appetites for novelty to show signs of satiation. Yet judging from consulting fees, book sales, and the proliferation of seminars, the corporate thirst for managerial innovations appears to be unquenchable.
Take the cases of reengineering and total quality management, two of the more pop- ular management techniques of the 1990s. One survey of 500 U.S. managers from large companies reported that 76 percent of the companies represented in the survey at least had tried TQM and that 69 percent had employed some form of reengineering.4
Such remarkable adoption rates spawned legions of management consultants, many of whom can be counted on to claim that TQM or reengineering is essential for the suc- cess of most if not all companies. There is even a highly coveted national prize, the Malcolm Baldrige National Quality Award, which is presented each year to the most successful application of the principles of total quality management.
But for all the hype, a significant number of TQM and reengineering programs have failed to live up to expectations. Press stories have expressed growing dissatis- faction with reengineering programs, to the point where the founders of the move- ment, James Champy and Michael Hammer, have shifted the focus of their consulting efforts away from downsizing initiatives and toward the pursuit of growth opportuni- ties. And reports of discontent with TQM began to appear in the early 1990s. For ex- ample, a Gallup poll of over 1,200 corporate employees in 1990 reported that al- though over half said that quality was top priority, only one-third considered their companies’ programs to be effective.5 A survey of 300 large companies conducted by The Wall Street Journal in 1991 found that executive satisfaction levels with TQM
3Schartner (1994), 15; and P. Milgrom and J. Roberts (1995), “Complementarities and Fit: Strategy, Structure,
and Organizational Change in Manufacturing,” Journal of Accounting and Economics 19, 179–208. 4Bain & Co. (1994), “Missions Possible,” The Globe and Mail (September 13), B22. 5B. Amanda (1990), “Quality Programs May Be Shoddy Stuff,” The Wall Street Journal (October 4) B1.
23-4 Part 4 Applications of Organizational Architecture
were only 40 percent.6 Some companies, such as McDonnell-Douglas Aircraft and Florida Power & Light, abandoned their TQM programs. After winning the Baldridge Award in 1990, Wallace Company filed for bankruptcy in 1992.7 Finally, a study of 584 United States, Canadian, German, and Japanese firms in 1991 concluded, “Many businesses may waste millions of dollars a year on quality-improvement strategies that don’t improve their performance and may even hamper it.”8
Such mixed reviews are not confined to TQM and reengineering. Evidence of the rise and fall of a larger sample of recent management innovations is presented in Figure 23.1, which displays the percentage of published business articles that mention a particular management technique in a given year. For example, as dis- played in the first graph in Figure 23.1, almost 1.5 percent of all business articles published in 1993 contained the words total quality management or TQM. The
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Figure 23.1 The Percentage of Business Articles Mentioning Various Management Techniques by Year
Among ABI/Inform articles that contain the words business, management, firm, or managers, the percentage of articles that mention selected management techniques between1970 and 1998.
6F. Bleakley (1993), “Best Laid Plans: Many Companies Try Management Fads,” The Wall Street Journal ( July 6), A1.
7J. Mathews (1992), “The Cost of Quality,” Newsweek (September 7), 48–49. 8G. Fuchsberg (1992), “‘Total Quality’ Is Termed Only Partial Success,” The Wall Street Journal (October 1), B7.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-5
graph also shows that, after reaching a peak in 1993, citations of TQM have fallen sharply. A similar pattern can be observed for reengineering, which achieved peak prominence in 1995. And two much-noted management preoccupations of the 1980s, just-in-time production and quality circles, have lost virtually all press cov- erage. The last four graphs—benchmarking, activity-based costing, outsourcing, and economic value added—represent still more recent innovations. Benchmarking and ABC are starting to fade; EVA and outsourcing continue to rise.9
If history offers any guide to the future, management techniques will continue to wax and wane. And new techniques—many of them reviving elements of older inno- vations—will doubtless appear.10 The rise and fall of such management techniques raise a number of important questions:
• What explains the popularity of these management innovations?
• Why do they often fail to produce their touted benefits?
• How can managers tell if a particular technique is appropriate given their firm’s circumstances?
• What can managers do to increase the likelihood that an adopted technique will be successful?
We use our organizational architecture framework to address these questions. Thinking in terms of organizational architecture can help managers evaluate ex- pected benefits and costs of management innovations for their own companies. As we argue below, virtually all management techniques focus on a specific problem confronting the organization, while ignoring possible effects of their proposed solu- tion on other aspects of the firm. In our terms, such programs typically affect one or two legs of the organizational architecture stool without careful consideration of their effect on the others. As one obvious example, a too rigid insistence on just- in-time principles can lead to big customer service problems; adopters of JIT at least should consider increases in the staffing (and perhaps the incentive pay) of their customer service department to accommodate such change. The organizational architecture framework we develop in this book can help managers considering one potentially valuable set of organizational changes to identify other facets of the organization that also require attention and complementary adjustment.
The Demand for Management Innovations With dramatic shifts in the business environment created by expanding deregulation, more rapid technological change, and more intense global competition, whole classes of firms face new challenges. For many companies, what once might have been appropriate architectures began to show signs of obsolescence. As a growing number of large, once-successful companies lose opportunities to smaller, more flexible (and, in some cases, overseas) competitors, the opportunity costs of ill-structured
9“FirstSearch,” an online referencing software, was used to gain access to ABI/Inform, a database containing
over 800,000 articles in 1,000 U.S. and international publications on business and management topics. To
calculate the percentage of articles published, the total number of business articles in a year was determined
by searching for the following: business, management, firm, or managers. 10The reader is cautioned against reading too much into Figure 23.1. Some of these management techniques still
may be used actively, but under another term. The press publishes articles about “new” topics. “Old” topics
are more difficult to attract the attention of journalists. However, the articles counted in Figure 23.1 are not
just articles that describe the particular technique, but rather are articles that simply mention the technique.
23-6 Part 4 Applications of Organizational Architecture
organizations are reflected in declining shareholder returns. This in turn increases the demand for management prescriptions that enable companies to respond more effectively to their new environment. Thus, we believe the demand for manage- ment innovations (or fads, as some refer to them) can be viewed as a rational economic response by executives to changes that cause aspects of their organiza- tional architectures to become obsolete.
The Rise of TQM11
Take the case of the broad-based adoption of TQM principles in the 1990s. Before TQM, the standard approach to ensuring product quality was to inspect it in. Inspec- tion stations and quality-assurance inspectors were placed along the production line to weed out defective units. Statistical sampling methods were used to draw random samples from each batch and, if an unacceptable number of substandard units was detected, the entire batch would be rejected.12 Defects were stored waiting to be re- worked or scrapped. In some cases, if market demand exceeded production over a period, marginally defective products might be released with problems corrected by the field service organization under warranty arrangements.
By the mid-1980s, two factors worked together to change this traditional ap- proach to quality within many industries. First was a change in technology: The cost of detecting problems and monitoring production using new computerized instru- mentation fell sharply relative to the cost of maintaining quality via manual inspec- tion or warranty repairs. Increases in the cost of labor (including fringe benefits) made the manual identification of errors and field service repairs considerably more expensive than doing it electronically. Instead of manually detecting and remedying defects after production, improved instrumentation allowed identification and cor- rection of problems during the manufacturing process.
A second key factor in the rise of TQM was the expansion of worldwide competi- tion. Besides price wars, competition also took the form of a push for higher-quality products. Customers shifted to more reliable products, many of whose producers were based overseas. Perhaps the most dramatic case of such quality-driven competition was the auto industry in the early 1980s. Once Japanese companies gained price com- petitiveness against American automakers, they focused their attention on achieving quality advantages.
Thus, the total quality movement was spurred by both lower costs of identifying defects and increased global competition. To reduce defects, companies redesigned their products to require fewer different parts, making it easier to maintain tighter controls on the quality of their suppliers. Product designers redesigned parts that failed. Production processes were changed to reduce defects. Robots and additional instrumentation in the manufacturing process ensured more uniform production.13
11This section draws on J. Zimmerman (2006), Accounting for Decision Making and Control, fifth edition, (Irwin/McGraw-Hill: Burr Ridge), Chapter 14.
12Statistical quality control (SQC) consists of a set of statistical methods used to determine if a particular
repetitive manufacturing process is in or out of control. By employing common statistical procedures (means
and standard deviations), normal variation of the process is established. If products exceed the normal
bounds, the process is deemed “out of control” and subject to management investigation. 13Other factors contributing to TQM were factory automation and flexible manufacturing that allowed firms
to broaden their product lines and to change products more rapidly. Because of these factors, at any time,
there are more products and more new products on the factory floor. This means there is likely more specific
knowledge on the shop floor now.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-7
Other Innovations
Although many TQM programs initially were started to improve the tangible aspects of product and service quality for external customers, TQM programs expanded to include efforts to improve both the quality and the efficiency of processes and services for internal as well as external customers. In this sense, the boundaries between TQM and another popular innovation, reengineering, have become somewhat blurred.
Reengineering One way of distinguishing between the two movements is to view reengineering as accomplishing a set of major, one-time changes,14 as opposed to TQM’s widely her- alded emphasis on continuous improvement. Like TQM, the demand for reengineer- ing stems from both technological changes and heightened competition in the 1980s. As Michael Jensen argued, we have experienced what amounts to a “third industrial revolution” over the past several decades.15 One major by-product of this wave of technological change has been more rapid product obsolescence and, as a conse- quence, overcapacity in certain global industries. Many of the major restructurings, consolidations, and downsizings associated with reengineering can be seen as value- adding (if not entirely voluntary) managerial responses to excess capacity.
JIT Technological advances in instrumentation, computers, and telecommunications also have been a key element in the rise of just-in-time production. Such advances have allowed factories to be redesigned along the continuous-flow lines required by
JIT vs. Homeland Security Following the 9/11 terrorist attacks, the U.S. Bureau of Customs and Border Protection established new rules for
international freight shipments entering the country by truck, rail, or ship. These regulations impose longer delays in
the inspection process for goods entering the United States. A United Parcel Service (UPS) spokesman warned that the
new requirements could “essentially eliminate” one-day delivery on international packages.
Given that many factory assembly lines are synchronized with deliveries, the longer border-crossing delays will
wreak havoc on these companies’ just-in-time production systems. Prior to the new rules, a General Motors supplier in
Windsor, Ontario, could cross the border in 15 minutes to make a delivery to a GM plant in Detroit. That time could
increase to 4 hours under the proposed rules, forcing the GM assembly process to shut down waiting for the parts.
Figure 11.1 describes how changes in the business environment, such as new regulations, can cause companies to
revise their strategies and eventually their organizational architecture. The new border-crossing regulations illustrate the
beginning of this chain reaction. Longer delay times for international shipments will trigger some firms to reevaluate and
possibly change their production strategies involving international outsourcing and just-in-time production methods.
Source: R. Brooks (2003), “Shippers Say New Border Rules Could Delay Just-in-Time Cargo,” The Wall Street Journal (August 29), A1.
H I S T O R I C A L A P P L I C AT I O N S
14As defined by Hammer and Champy, reengineering is “the fundamental rethinking and radical redesign of
business processes to achieve dramatic improvements in critical, contemporary measures of performance,
such as cost, quality, service, and speed.” M. Hammer and J. Champy (1993), Reengineering the Corporation: A Manifesto for Business Revolution (Harper Business: New York), 32.
15M. Jensen (1993), “The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems,”
Journal of Finance 48, 831–880.
23-8 Part 4 Applications of Organizational Architecture
JIT. Suppliers’ computers are linked electronically to their customers’ computers, and electronic order processing is commonplace. But, if JIT has been made possible by technological change, its demand also reflects a major change in market conditions. Large corporate customers increasingly are demanding that their suppliers deliver products in continuous, small-order lot sizes—in part to reduce their own inventories and hence to improve efficiency.
Outsourcing As part of the process of shedding excess assets and capital to increase operating ef- ficiency and shareholder value, many U.S. companies also pursued a refocusing strategy during the 1980s and 1990s. Along with selling or spinning off unrelated businesses, outsourcing of previously internal functions was a widely practiced method for sharpening corporate focus. Outsourcing involves a fundamental change in organizational architecture. It reassigns ownership of certain assets, decision rights, and, in many cases, the employees who exercised them from inside the com- pany to another firm. Recall the Chapter 19 example in which Eastman Kodak sold its mainframe computers to IBM and contracted with IBM to do much of Kodak’s data processing. Such partnerships have been prompted in part by changes in the in- formation technology that have made it easier to identify and communicate with partners outside the firm. Also, more flexible production technologies have reduced asset specificity, thus reducing the costs of outsourcing. Besides allowing manage- ment to focus more of their attention on those internal activities where they have a comparative advantage, outsourcing also enables companies to acquire goods and services from other firms at lower prices by allowing the latter to specialize and achieve economies of scale.
Why Management Innovations Often Fail As we noted earlier, many companies adopting new management techniques have been less than enthusiastic with the outcomes. We now explore potential explana- tions for this dissatisfaction—and, more generally, for the tendency for successful in- novations to rise sharply and then (often just as abruptly) to fall out of favor, thus prompting skeptics to brand them as fads.
Marketing
The demand for management solutions is met predictably by responses from con- sulting firms, academics, and management gurus (and these groups are not mutually exclusive). Frequently, a consultant working with a client firm identifies a specific set of problems and recommends a package of changes. Especially if implementing the changes appears to improve the operation of the client firm, the consultant quite naturally next seeks to identify other potential clients who face similar circum- stances. Producing a successful management innovation is difficult, but the rewards can be enormous. One challenge potential innovators face is that property rights in management innovations are generally ill-defined. Because of this, labels are quite important. Innovators frequently attempt to brand their innovation with a new term like reengineering, benchmarking, or organizational architecture.16
16Good acronyms appear helpful (TQM, ABC, MBO). The Holy Grail in this business appears to be having a
new acronym registered (EVA®).
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-9
Setting Inappropriate Expectations One potential explanation for managerial dissatisfaction is that consultants create inappropriate expectations in marketing management innovations. They frequently claim that their technique will increase productivity and raise profits. But if com- peting firms in the industry also adopt the technique, any abnormal profits are competed away. A basis for sustainable profits cannot be an asset that competitors can replicate. Thus, although effective and productive, adoption is not followed by higher profits. (Here, the appropriate comparison is not future profits against past profits, but future profits with the innovation versus future profits were it not adopted.)
A second explanation focuses on the incentives of purveyors of a given manage- ment innovation to emphasize expected benefits while understating costs. This is not to suggest that management consultants are less honest or less forthright than the rest of us. Yet as proponents as well as beneficiaries of change, consultants are likely to provide detailed information on companies where their techniques appeared to work but less information on those where their techniques failed. And having acquired knowledge and experience in addressing a set of specific corporate issues and problems, consultants are understandably less informed about other aspects and concerns of the organization. As we argue later, it is the potential linkages or interdependencies among these sets of problems that frequently lead to unintended and undesired consequences when making organizational changes.
Of course, managers recognize that consultants have incentives to present an optimistic view of their services. And most managers attempt to adjust for such bias when deciding whether, or to what extent, to implement a consultant’s recommenda- tions. But even so, the corporate failure rate in adopting management innovations obviously would be lower if managers had a low-cost, unbiased source of information at their disposal.
Quality Is Not Free In some instances, management consultants have offered advice that simply defies economic logic. Perhaps the most egregious example is noted quality expert Phillip Crosby’s assertion, contained in the title of his 1980 book, that Quality Is Free. On page 1 Crosby writes,
If you concentrate on making quality certain, you can probably increase your profit by an amount equal to 5 to 10 percent of your sales. That is a lot of money for free. . . . What costs money are the unquality things—all the actions that involve not doing jobs right the first time.17
Included in Crosby’s list of the costs of “not doing things right the first time” are unnecessary or excessive costs associated with prevention of defects (design reviews, supplier evaluations, tool control, preventive maintenance), quality moni- toring (prototype tests, receiving inspection and test, packaging inspection), and the costs associated with preventable failures (including the costs of redesign, engineer- ing change orders, rework, scrap, product warranty, and product liability).
But what does Crosby really mean when he says, “Quality is free”? Taken literally, the statement suggests that managers can achieve substantial reductions in product failures, and in the costs associated with preventing them, at no cost to the organization. But this can’t be the intended meaning for, as Crosby surely knows,
17P. Crosby (1980), Quality Is Free (Mentor: New York), 1.
23-10 Part 4 Applications of Organizational Architecture
improving product quality clearly requires a major commitment of management time as well as other corporate resources. Defects must be discovered, their causes investigated and corrected, employees must be trained in quality methods, and prod- ucts redesigned. In fact, improving quality can be quite costly.
Rather than think of quality in Crosby’s terms, it makes economic sense to view a TQM initiative as an investment of corporate resources with an uncertain future re- turn in the form of lower costs or higher revenues, or both. Improving product qual- ity usually lowers the cost of reworking defects along with inspection costs, warranty costs, and customer complaints. And, to the extent the firm’s brand-name capital is higher when product quality is increased, product demand and hence revenues will increase. But, given the commitment of resources necessary to achieve such in- creases in quality, the critical question for senior management becomes: Does the ex- pected rate of return justify the initial and ongoing investment, including the man- agement effort and other costs associated with changing the organization?18 Crosby asserts that the answer to this question—for all companies and for arbitrarily large commitments, as far as we can tell—is yes. We are unconvinced.
The assertion that quality is free also obscures the reality that it typically requires larger investments of corporate resources to attain higher levels of quality and that, at some point, all companies face diminishing marginal returns from further invest- ments in quality programs. This in turn implies that there is generally an “optimal,” or value-maximizing, level of quality.
Figure 23.2 depicts the normal relation between quality and the firm’s value. At relatively low levels of quality (where the curve is rising), increases in quality lead to increases in firm value in two ways: by reducing production, inspection, and warranty costs and by increasing consumer demand for, and the prices commanded by, the products. But, at some point (represented by Q*), the returns to further in- vestment in quality-increasing measures fall below acceptable levels. Ultimately, it is the company’s customers who must pay for the cost of enhanced quality. At some point, the costs of additional improvements in quality exceed the premium customers are willing to pay—along with any further production cost savings. To
F ir m
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Figure 23.2 The Relation between Quality and Firm Value
Firm value increases as quality increases because consumer demand increases and costs decline. Beyond Q*, the cost of increasing quality is greater than the manufacturing cost savings and the increased consumer demand. Maximizing quality does not maximize firm value. Too much quality lowers value.
18P. Lederer and S. Rhee (1995), “Economics of Total Quality Management,” Journal of Operations Management 12, 353–367.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-11
illustrate, wine lists at many restaurants contain a wide selection encompassing a range of prices; yet even though the quality of the highest-priced wine presumably is commensurate with its price, few diners seem to place enough value on the higher quality of the $275 bottle of 30-year-old imported Chateau Margeaux to order it in- stead of the $20 bottle of the 3-year-old domestic house wine. Value-maximizing managers will want to undertake only those quality improvements where the in- cremental benefits exceed the incremental costs of enhanced quality.
Perhaps one way to make sense of Crosby’s statement would be to argue that some managers systematically underestimate the total costs of poor quality. For ex- ample, some companies might place too much emphasis on short-term financial measures. Or, if managers are about to retire, they might be reluctant to spend money today on quality programs that yield benefits after they retire. But this is just the stan- dard horizon problem that confronts all decisions where the expected benefits of pre- sent outlays span several periods. In this sense, quality programs are no different from capital investments, R&D, or advertising. Successful firms find ways to control these horizon problems.
An alternative explanation is that some managers underestimate the costs of low quality out of ignorance. Those managers who fail to appreciate the costs of reduced consumer confidence in their products will underestimate the benefits of reducing defects and so underinvest in programs to improve quality. In cases where such my- opic behavior is common, companies might benefit from educational programs fo- cused on the importance of quality.
But regardless of whether underinvestment in quality might be attributed to igno- rance or distorted incentives, quality still is not free. Decisions to improve quality, like all corporate investment decisions, require accurate estimates of all expected costs and benefits. It is just as dangerous to underestimate the costs of quality pro- grams by arguing that quality is free as it is to underestimate their benefits. As many companies likely have discovered, overinvestment in quality-improvement programs can end up destroying just as much value as underinvestment. Management’s job is to find the value-maximizing level of quality—neither too much nor too little—based on the firm’s markets and internal capabilities.
Underestimating Costs of Change
Another important reason TQM and other management innovations can prove inef- fective is that some managers underestimate the costs of change. As we saw earlier, changes in market conditions, technology, or government regulation can affect opti- mal architecture. But as we argued in Chapter 11, organizational change is by no means a costless process. In evaluating the merits of an organizational restructuring, it is important to assess these costs in addition to its benefits.
First, there are direct costs. The new architecture has to be designed and commu- nicated. Changes in reporting structures and performance-measurement systems fre- quently impose costly changes on the firm’s accounting and information systems; what might appear to be a minor change in the performance-evaluation system sometimes becomes a quite costly project for the firm’s information systems and accounting departments.
Second, and at times more important, are indirect costs. Most changes in architec- ture will affect some employees positively but others negatively. Thus, attitudes toward change can be expected to vary among employees, creating incentive problems
23-12 Part 4 Applications of Organizational Architecture
that are costly to control. And recurrent changes in architecture can have undesirable incentive effects. Increasing the likelihood of change reduces employees’ incentives to invest in learning current assignments, devising more efficient production processes, or developing relationships with teammates. Constant restructuring promotes more focus on shorter-run payoffs and less on longer-run investments.
Failure to Consider Other Legs of the Stool
Perhaps the most important reason management innovations often fail, however, is their failure to address all three components of organizational architecture. In Table 23.1 we list a set of popular management techniques along with their primary focus.
For example, let’s go back to the case of TQM. As shown in Table 23.1, TQM pro- grams typically change both decision rights and performance measures, but leave the reward system largely unchanged. And this appears to be by design. Echoing quality- guru W. Edwards Deming’s well-known disdain for financial incentives, Crosby argues,
People really don’t work for money. They go to work for it, but once the salary has been established, their concern is appreciation. Recognize their contribution publicly and noisily, but don’t demean them by applying a price tag to everything.19
Assignment of Performance Reward Decision Rights Evaluation System
Total quality management X X Reengineering X Outsourcing X Just-in-time production X Quality circles X X Benchmarking* X X X Activity-based costing X Economic value added X X Empowerment X Self-directed teams X X Venturing X Incentive compensation X Cycle-time reduction X Strategic alliances X Management by objectives X 360° performance reviews X Matrix organizations X
*Any corporate policy can be benchmarked; thus benchmarking can be applied to all parts of the organization’s architecture. However, in practice, firms often benchmark only one facet of the organization.
Table 23.1 Focus of Management Techniques
For each management technique, we indicate whether it focuses on decision-rights, performance-evaluation, or the reward system.
19Crosby (1980), 218.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-13
Apparently, this strategy has been adopted widely. For instance, a 1992 study by the American Quality Foundation and Ernst & Young found that quality performance measures were not important variables in determining senior managers’ compensa- tion in 80 percent of the firms surveyed.20
We would suggest otherwise. In pushing decision rights down to the people with the knowledge about processes and customer preferences, it is important that companies use their reward systems to reinforce their new performance-evaluation systems.21
Critics of incentive compensation like Crosby argue that pay for performance does not work because it ends up rewarding people for doing the wrong things. And such criticism is undoubtedly correct in the sense that an ill-designed compensation system indeed can elicit dysfunctional behavior. But Crosby’s ar- gument alone is not sufficient reason to conclude that incentive pay should be abandoned. Monetary and nonmonetary incentives are not mutually exclusive— employees clearly value both types of rewards.22 A recurring theme in this book is that appropriately linking financial incentives to the new performance measures will reinforce the desired changes in behavior.
Reengineering A similar criticism can be directed toward many reengineering programs. As suggested in Table 23.1, reengineering focuses almost exclusively on a single leg of our three-legged stool: the reassignment of decision rights. Most advocates of reengineering pay lip service to the importance of the performance-evaluation and reward systems, but offer little guidance—and, in some cases, inappropriate advice—as to how the evaluation and reward systems must change. For example, the best-known advocates of reengineering, Hammer and Champy, are content to provide only the following advice: “Substantial rewards for outstanding perfor- mance take the form of bonuses, not pay raises.”23 The compensation decision is far more critical to outcomes than this treatment by Hammer and Champy suggests.
For example, one important part of corporate performance/reward systems is pro- motions. By creating smaller, flatter organizations, reengineering reduces advance- ment opportunities. But most reengineering articles are completely silent about how to create new career paths and promotion systems to motivate individuals within a flatter, process-oriented organization. As in the case of TQM, to increase the chances that reengineering efforts will succeed, substantial managerial attention also must be focused on reengineering the performance-evaluation and reward systems.
EVA On the other hand, an exclusive concern with performance evaluation and rewards also can cause problems. Take the case of economic value added, which attempts to make the economist’s concept of residual income the basis for incentive compensation, not
20R. Jacob (1993), “TQM: More Than a Dying Fad?” Fortune (October 8), 68. 21See K. Wruck and M. Jensen (1994), “Science, Specific Knowledge, and Total Quality Management,”
Journal of Accounting and Economics 18, 247–287. 22G. Baker, M. Jensen, and K. Murphy (1988), “Compensation and Incentives: Practice vs. Theory,” Journal
of Finance 43, 593–616. 23M. Hammer and J. Champy (1993), 73.
23-14 Part 4 Applications of Organizational Architecture
only for corporate executives and senior divisional managers, but for rewards that ex- tend “all the way down to the shop floor.” Yet such a prescription easily can backfire if it fails to take into account the limited decision rights (and risk-bearing capacity) of lower-level employees. Employees with little control over factors that drive their busi- ness unit’s EVA may find little motivation—in fact, may be subjected to excessive risk bearing—by such an evaluation and reward system.
ABC As one final example, let’s use our organizational architecture framework to explore why the practical achievements of another innovation listed in Table 23.1 have fallen well short of some managers’ expectations. In the late 1980s and early 1990s a new accounting system, activity-based costing, appeared to great acclaim. An article in Fortune magazine declared, “Trim waste! Improve service! Increase productivity! But it does all that—and more.”24
How does ABC work? Under traditional accounting systems, overhead costs of common resources such as engineering services are allocated to products or lines of business using very simple formulas, such as percentage of direct labor or percent- age of total revenue. For example, suppose both riding and walk-behind lawn mow- ers are produced in the same plant and both models use common resources. In cal- culating the accounting costs of the mowers, the plant’s overhead costs traditionally are allocated to mowers based on the percentage of direct labor charged to each mower. If direct labor is an unreliable indicator of the level of manufacturing over- head a given operation really generates, this traditional system misrepresents costs. For example, in the case of more complicated products involving little direct labor but a great deal of engineering services, the costs of these products will be under- stated; managers using such costs to guide pricing decisions might charge too little for them.
Under ABC, different categories of overhead such as purchasing, engineering, and inspection are assigned to products based on underlying cost drivers of that over- head department. For example, purchasing department costs are allocated to differ- ent products based on the quantity of purchase orders issued or the number of differ- ent parts purchased for each product. By so doing, ABC is said to provide a more accurate estimate of a product’s real costs and, hence, a more reliable basis for deci- sion making than the traditional numbers.
But for all its theoretical appeal, the promise of ABC largely has failed to materi- alize. Although many companies have investigated ABC systems and some have conducted pilot studies, few have abandoned their older, simpler cost-allocation methods. Even though some firms employ ABC-based numbers for special studies, they continue to base performance evaluation on their traditional accounting systems.25
One important reason ABC is not replacing traditional accounting systems for purposes of performance evaluation goes back to the standard admonition against giving control of the accounting system to the people being monitored by that
24T. Paré (1993), “A New Tool for Managing Costs,” Fortune ( June 14), 124–129. 25See A. Sullivan and K. Smith (1993), “What Is Really Happening to Cost Management Systems in U.S.
Manufacturing?” Review of Business Studies 2, 51–68; R. Cooper, R. Kaplan, L. Maisel, E. Morrissey, and R. Oehm (1992), “From ABC to ABM,” Management Accounting 74, 54–57; and Cost Management Update, newsletter published by the Cost Management Group of the National Association of Accountants, Inc. ( January 1991).
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-15
system—the separation of decision management and decision control. ABC systems typically must be designed by operating managers because they are the people with the greatest specific knowledge of the overhead cost drivers. Yet these are precisely the people whose performance the ABC measures are intended to evaluate.
But it’s not just the opportunity it provides operating managers for self-enrich- ment that makes most companies reluctant to adopt ABC for performance evalua- tion. It’s the internal turmoil that such changes potentially unleash—influence costs that we discussed in Chapter 12. Altering accounting cost allocations creates both winners and losers in the process. And people can be counted on to struggle might- ily to ensure that they are among the winners. The fact that a good deal of subjective judgment goes into determining these ABC measures means that the internal battles are likely to be long, hard-fought, and costly.
As an example of influence costs, one firm implemented and then abandoned activity-based costing after only a year. The controller explained that under the old system, with just a few cost drivers, everyone understood the weaknesses of the sys- tem and accepted its faults. With the new system, managers were constantly arguing over the appropriate cost drivers because switching cost drivers changed product costs and thus managers’ performance measures. Valuable management and em- ployee time was consumed debating the merits of particular cost drivers. To put an end to the bickering, the controller abandoned ABC.
Because ABC changes product costs and hence product-line profits, successful implementation of ABC throughout the firm requires that new profit targets be es- tablished for managers with profit responsibility. To control influence costs, the new profit targets should attempt to eliminate any windfall gains and losses for these managers arising from the change to ABC. This requires detailed changes in compensation plans.
Thus, one of the main reasons ABC has failed to achieve widespread adoption is that it changes only one of the three legs of the firm’s organizational architecture stool—the performance-evaluation system. Without complementary changes in decision-right assignments and performance rewards (such as establishing new profit targets in compensation plans), there is little basis for expecting that firm performance will be enhanced.
ABC and Business Strategy Although ABC strives to produce more accurate product costs—a laudable goal—obtaining and using more accurate
product costs actually could work against the firm’s business strategy. For example, suppose a firm is unionized, and
reducing labor content is part of its business strategy. Changing the overhead allocation base from direct labor to, say,
number of different parts in the product will weaken managers’ incentives to reduce labor content by effectively
lowering the implicit tax on labor because overheads no longer are allocated on the basis of direct labor content.
Take the case of Hitachi, a large Japanese electronics producer, which manufactures VCRs in one of its plants. Even
though this plant is highly automated, and the managers know that direct labor does not reflect the cause-and-effect
relation between overhead and the overhead cost drivers, Hitachi continues to allocate overhead using direct labor to
reinforce the managers’ commitment to further automation. Taxing direct labor through conventional cost accounting is
one way to accomplish this aim, thereby lowering production costs.
Source: T. Hiromoto (1988), “Another Hidden Edge—Japanese Management Accounting,” Harvard Business Review 66, 22.
A C A D E M I C A P P L I C AT I O N S
23-16 Part 4 Applications of Organizational Architecture
Managing Changes in Organizational Architecture Our point in insisting that changes in architecture be coordinated is not to suggest that all facets of the firm’s architecture must be changed simultaneously. Rather, we argue the importance of understanding the entire set of policies that must be changed and developing a plan for implementing that set of changes. An effective plan for im- plementing a major reorganization often will specify that changes be accomplished sequentially—perhaps in stages—rather than all at once.
Perhaps an analogy will help. Watch a good teaching golf pro giving lessons. The pro knows that there are at least 30 different factors that have to come together to hit a per- fect shot—factors such as grip, stance, take-away, position at top, swing plane, release, tempo, and follow-through. After watching a new pupil hit only a few balls, the pro rec- ognizes at least a dozen things that are not quite right. But rather than tell the duffer to think about the dozen things at once, a good teacher will identify the major problem and focus the pupil’s attention on fixing that one aspect of the game. In future lessons, the other problems will be addressed in turn. The pro knows that asking someone to think about too many things at once makes it virtually impossible to hit the ball. Thus, to pro- duce better shots, the pro plans a sequence of lessons that, over time, will correct the problems and improve the game. As the legendary golf instructor Harvey Penick put it: “You have to make corrections in your game a little bit at a time. It’s like taking aspirin. A few will probably cure what ails you, but the whole bottle might just kill you.”
Fostering major change within an organization frequently takes the same tack. Telling employees that everything is going to be changed creates uncertainty, anxiety, and confusion—productivity suffers. Senior management does not have enough resources to oversee changing everything. Identifying the organization’s major problem and focusing employees’ attention on changing that facet of the organization is difficult enough. After that change is digested, additional complementary changes can be instituted.
This view of the process of organizational change suggests that corporate execu- tives should understand their basic business environment and have a good sense of the kinds of organizational changes that are required to enhance performance. To help form a better sense of the entire set of changes, they might retain a consulting firm for assistance. But again, it is important to recognize that consulting firms nat- urally specialize in specific problems and techniques. And even though management might benefit from the specific knowledge and experience of such specialists in implementing particular types of organizational change, costly problems may arise from consulting firms’ lack of experience in dealing with issues of required comple- mentary changes in other facets of the organization outside their area of expertise.
M A N A G E R I A L A P P L I C AT I O N S
Sequencing Organizational Changes at GM Choosing the appropriate sequence for implementing organizational changes can be quite important; costly problems
can arise if this is not done well. Consider the case of General Motors in its attempts to implement additional
outsourcing after adopting just-in-time inventory policies. When GM announced that it was planning to outsource more
of its activities, workers at its Dayton brake plant went out on strike. Because of its JIT program, within a week, GM
auto production throughout North America was severely curtailed. The walkout by this local’s 3,000 members idled
over 43,000 GM workers and closed 12 assembly plants.
In effect, the JIT program had increased the local union’s bargaining power substantially. Under its old policy, GM
would have had an inventory of brakes sufficient to meet production demands for several months, thus giving the
company more time to negotiate without affecting overall auto production.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-17
ANALYZING MANAGERIAL DECISIONS: Software Development, Inc.
Software Development, Inc., produces and markets
software for personal computers, including spread-
sheet, word processing, desktop publishing, and
database management programs. SDI has annual
sales of $800 million.
Producing software is a time-consuming, labor-
intensive process. Software quality is an extremely
important aspect of success in computer software
markets. One aspect of quality is program reliability.
Does the software perform as expected? Does it work
Software Maintenance
Number of Product Training Prevention and Customer Defects Cost Cost Cost Service Cost Total Cost
1 66 $3,455 $442 $ 770 $2,160 $6,827 2 86 3,959 428 447 2,658 7,492 3 14 3,609 417 1,167 687 5,880 4 73 3,948 211 655 2,334 7,148 5 17 3,104 290 1,013 544 4,951 6 48 3,179 253 547 1,556 5,535 7 80 3,112 392 508 2,633 6,645 8 41 3,529 276 577 1,563 5,945 9 50 3,796 557 634 1,666 6,653
10 67 3,444 365 947 2,140 6,896 11 42 3,922 453 869 1,444 6,688 12 64 3,846 378 1,108 1,942 7,274 13 71 3,014 555 762 2,384 6,715 14 1 3,884 301 773 423 5,381 15 18 3,183 378 1,080 857 5,498 16 85 3,475 528 1,010 2,572 7,585 17 17 3,445 357 666 631 5,099 18 50 3,203 285 427 1,546 5,461 19 22 3,839 239 1,080 891 6,049 20 73 3,060 540 1,054 2,309 6,963 21 52 3,182 329 1,079 1,867 6,457 22 75 3,075 395 832 2,697 6,999 23 35 3,456 447 969 1,518 6,390 24 53 3,987 355 651 2,042 7,035 25 25 3,836 309 1,160 1,036 6,341 26 6 3,886 234 794 252 5,166 27 78 3,846 418 833 2,800 7,897 28 82 3,106 409 1,092 2,871 7,478 29 39 3,506 448 899 1,342 6,195 30 47 3,545 450 442 1,450 5,887 31 30 3,376 456 784 1,260 5,876 32 17 3,740 542 420 607 5,309 33 67 3,479 411 821 2,018 6,729 34 51 3,773 351 1,145 1,873 7,142 35 74 3,034 497 671 2,389 6,591 36 25 3,768 268 887 1,094 6,017 37 14 3,168 356 645 837 5,006 38 77 3,561 492 1,167 2,597 7,817 Average 48 $3,509 $390 $ 826 $1,671 $6,395
Table 23.2 SDI Defects and Costs by Program Release (per 100,000 lines of computer code)
23-18 Part 4 Applications of Organizational Architecture
with other software in terms of data transfers and in-
terfaces? Does it terminate abnormally? In spite of
extensive testing of the software, programs always
contain some “bugs” (defects). Once the software is
released, SDI stands behind the product with phone-
in customer service consultants who answer ques-
tions and help the customer work around existing
problems in the software. SDI also has a software
maintenance group that fixes bugs and sends out re-
vised versions of the programs to customers.
SDI has been tracking the relation between qual-
ity costs and quality. The quality measure it uses is
the number of documented bugs in a software
package. These bugs are counted when a customer
calls in with a complaint and the SDI customer ser-
vice representative determines that this is a new
problem. The software maintenance programmers
then set about fixing the program to eliminate the
bug. To manage quality, SDI tracks quality costs. It
has released 38 new or major revisions in existing
packages during the last three years. Table 23.2
reports the number of defects documented in the
first 6 months following release. Also listed in
Table 23.2 is total product cost and quality cost per
software package release.
Product cost includes all the costs incurred to
produce and market the software, excluding the
quality cost in Table 23.2. Quality cost consists of
these components: training, prevention, and soft-
ware maintenance and customer service costs.
Training costs are those expenditures for educating
the programmers and updating their training.
Better-educated programmers produce fewer bugs.
Prevention cost includes the expenditures for test-
ing the software before it is released. Maintenance
and customer service costs are those of the pro-
grammers charged with fixing the bugs and reissu-
ing the revised software and the customer service
representatives answering phone questions. The
training and prevention costs are measured over the
period the software is being developed, and the
number of bugs and the maintenance and service
costs are measured in the first six months following
release.
All the numbers in Table 23.2 have been divided
by lines of computer code in the particular program
release. Programs with more lines of code cost
more and also have more bugs. Prior studies find
that using lines of code is an acceptable way to
control for program complexity. Thus, the numbers
in Table 23.2 are stated in terms of defects and cost
per 100,000 lines of code.
Figure 23.3 depicts the relation between total
quality cost and number of defects. The vice presi-
dent of quality of SDI likes to use Figure 23.3 to em-
phasize that costs and quality are inversely related.
8,000
7,000
6,000
5,000
4,000 100 80 60 40 20 0
Number of defects
To ta
l c o st
s (i n d
o lla
rs )
X X
XX X X
X X
X XX
X X
X
X X
X
X X X X
XXX
X
X
X X
XX X
X
X XX
XX
X
$
N
Figure 23.3 SDI Total Costs by Defects
SDI tracks the number of defects reported in the first 6 months following release and quality costs for each of the 38 revisions over the past 3 years. Product cost includes costs incurred to produce and market the software. Quality costs consist of training, prevention, software maintenance, and customer-service costs. All the numbers are expressed per 100,000 lines of computer code.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-19
Summary In reviewing the business literature over the past 30 years, we find an essentially con- tinuous stream of articles decrying then current management fads. Here are two sam- ples from the 1970s:
Companies have developed many special devices to meet specific needs in their executive com- pensation plans. But other companies, wishing to be up to date, have indiscriminately put these devices in their own plans. The results have been—to say the least—embarrassing. The fads in- clude: see-saw options, split-dollar insurance, . . . 26
Perhaps the greatest time waste of all is the casting about after fads in Organizational Development, such as constantly jumping on the bandwagons and mindlessly switching from T Group to Team Building, Transactional Analysis, Gestalt Approaches, etc.27
Or consider a more recent example:
If a manager achieves success, the world comes asking for the key to that success. Organization after organization embraces the latest management fads, of which there certainly is no short- age. . . . Total Quality Management (TQM), like so many other elixirs, did not fail for compa- nies because the idea was bad. TQM failed because managers dealt with it superficially.28
These articles all argue in one way or another that uncritical adoption of the man- agerial innovation du jour is a prescription for disaster. Yet new management tools are being introduced and adopted continually. We believe it is advantageous to un- derstand the market for management innovations in order to make reasoned deci- sions about whether your organization might benefit from the newest management technique.
Environmental Change Prompts Innovation Management innovations gener- ally arise as responses to material changes in technology, competition, or regulation. Since such environmental change frequently has similar impacts on a broad array of firms, there is a potentially large market for appropriate organizational responses to those new circumstances. Thus, for all their fadlike behavior, the persistence of management innovations suggests they serve a useful purpose; the benefits of such innovations, at least on average, exceed their costs. For example, if the external en- vironment changes—say, because of technological advances or global competi- tion—a formerly successful, growing firm suddenly can find itself unable to compete
She is fond of saying, “Quality pays! Our total costs
are a declining function of the number of defects.
The more we spend on quality, the lower our costs.”
Based on this analysis, the vice president has recom-
mended a major investment in quality improvement,
focusing specifically on prevention and training.
Evaluate the vice president’s analysis:
1. What criteria should be used in deciding
whether to invest more in quality?
2. Do you have sufficient data to evaluate such an
investment proposal?
26D. Thomsen (1973), “Executive Compensation Gimmicks: Look Out!” Financial Executive (August), 58–66.
27T. Patten (1977), “Time for Organizational Development,” Personnel (March–April), 26–33. 28G. Shelley (1996), “The Search for the Universal Management Elixir,” Business Quarterly (Summer),
11–13.
23-20 Part 4 Applications of Organizational Architecture
effectively; these environmental changes have made the firm’s current strategy and or- ganizational architecture obsolete. Changes are required if the firm is to survive and again prosper. And because changing corporate cultures can be quite difficult, some external change agent frequently is useful. The latest management technique often can prove a productive mechanism for suggesting facets of the organization that re- quire adjustment as well as for focusing the organization on implementing these changes. Hence, the current innovation can provide a special opportunity to intro- duce major changes in strategy and architecture.
If It Ain’t Broke, Don’t Fix It Adopting the most recent innovation can destroy value unless the change is warranted by the actual circumstances your firm faces. Unfortunately, some firms appear to adopt changes without careful analysis of the relevant costs and benefits. Figure 11.1 describes the interrelations among a firm’s external environment, business strategy, organizational architecture, and value. As discussed in Chapter 8, it is important that managers continually monitor their exter- nal business environment as well as internal strengths and weaknesses to identify po- tentially appropriate strategic changes. Material changes in the external environment require modification of your business strategy, and likely adjustments to your orga- nizational architecture. But if the environment is relatively stable, a successful firm should be extremely cautious about undertaking massive changes in corporate strat- egy or organizational architecture.
One Size Doesn’t Fit All Not all firms would benefit from outsourcing, improving quality, empowerment, or any other management innovation. Just because a particular management technique appears to have increased value for one firm in no sense im- plies that adoption would raise your firm’s value, as well. Again, only if your firm’s current strategy or architecture no longer fits should you consider major changes.
Ensure That the Stool Is Balanced At any point in time, you face an array of prominent management techniques—each touted as the key to success. Most of these techniques involve fundamental changes in organizational architecture but tend to target one aspect of business strategy or organizational architecture— decision rights, performance evaluation, or rewards—while slighting the rest. For example, advocates of reengineering recommend changing the delegation of deci- sion rights and task assignments. Just as none of these recent management techniques provides coordinated advice for changing all three components of the firm’s organizational architecture, we expect that future innovations will fail to do so, as well. Yet changes that leave one leg of the stool out of balance mean that the firm’s organizational architecture no longer fits and hence requires coordinated adjustment.
Don’t Bite Off More Than You Can Chew If you do decide to make a change in one aspect of the organization, then you should anticipate the effects of such change on other aspects and plan the implementation of complementary adjustments neces- sary to accommodate such change. Arguing that it is important to consider all three legs of the stool in designing an appropriate architecture does not imply that all changes must be implemented simultaneously. Changing too many aspects of the firm at one time can be difficult to digest and productivity can suffer. You need to un- derstand your environment, formulate strategy, and devise a plan for implementing the entire array of required changes.
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-21
Organizational Change Checklist When analyzing business problems and challenges, managers often find it useful to ask themselves the following set of questions:
• Does our existing business strategy fit the business environment—technology, market conditions, and regulation—and the capabilities of our firm?
• What are the key features of our current architecture? And does our architec- ture fit our business environment and strategy?
• Are the three legs of the organizational architecture stool mutually consistent? Given the decision-right system, do the control and reward systems fit and vice versa?
• If the answers to any of the previous questions suggest a problem, what changes in strategy and architecture should the firm consider?
• What problems will our firm face in implementing these changes? What can be done to increase the probability of success?
In Closing It is critical to recognize that these policy choices represent funda- mentally difficult organizational decisions. Across firms, public data on these inter- nal organizational policies are limited, in part because management considers this information proprietary and in part because this information is not easy to summa- rize and aggregate. Finally, the interrelations among the various dimensions of the problem imply that these policy choices are inherently complex. When making such decisions, information costs are high and errors are potentially substantial. Thus, it is useful to recall Yogi Berra’s observation: “You got to be careful if you don’t know where you’re going, because you might not get there.” We believe that the organi- zational architecture framework we develop in this book can help by giving you a more detailed understanding of “where you’re going”—it better focuses your attention and thus helps you frame better questions. Nonetheless, answers still are quite difficult. Yet by asking better, more focused questions and structuring more complete, coherent analysis, this framework helps ensure that you will in fact “get there.”
P. Crosby (1980), Quality Is Free (Mentor: New York).
M. Hammer and J. Champy (1993), Reengineering the Corporation: A Manifesto for Business Rev- olution (Harper Business: New York).
J. Juran (1989), Juran on Leadership for Quality (Free Press: New York).
J. Juran and Gryna, Jr. (1993), Quality Planning and Analysis (McGraw-Hill: New York).
S. Keating and K. Wruck (1994), “Sterling Chemicals Inc.: Quality and Process Improvement
Program,” Harvard Business School Case 9-493-026.
K. Wruck and M. Jensen (1994), “Science, Specific Knowledge and Total Quality Management,”
Journal of Accounting and Economics 18, 247–287.
23–1. “Hewlett-Packard now treats TQM like any other investment: If a particular total-quality initiative doesn’t show a quick return in terms of higher sales, lower costs, or happier cus-
tomers, it is redesigned or scrapped.”29 Critically evaluate Hewlett-Packard’s policy.
Review Questions
Suggested Readings
29“The Straining of Quality,” The Economist (January 14, 1995), 55.
23-22 Part 4 Applications of Organizational Architecture
23–2. Guest Watches is a division of Guest Fashions, a large international fashion designer. Guest Watches manufactures highly stylish watches for young adults (ages 18 to 30) who
are fashion-conscious. It is a profit center and its senior management’s compensation is
tied closely to the watch division’s reported profits. Guest Watches has succeeded in
capturing the fashion market, but a lack of product dependability is eroding these gains. A
number of retailers have dropped or are threatening to drop the Guest watch line because
of customer returns. Guest Watches carry a 1-year warranty, and 12 percent are returned,
compared to an industry average of 4 percent. Besides high warranty costs and lost sales
due to reputation, Guest has higher-than-industry average manufacturing scrap and re-
work costs.
Senior management, worried about these trends and the possible erosion of its market
dominance, hired a consulting firm to study the problem and make recommendations for
reversing the situation. After a thorough analysis of Guest’s customers, suppliers, and
manufacturing facilities, the consultants recommended five possible actions, ranging from
the status quo to a complete total quality management, zero defects program (level IV). The table below outlines the various alternatives (in thousands of dollars):
Additional Additional Prevention/ Training Cost* Compliance†
Status quo $ 0 $ 0 Level I 80 180 Level II 200 240 Level III 350 340 Level IV 550 490
*Includes the annual costs of training employees in TQM methods. †All annual costs, including certifying suppliers, redesigning the product, and inspection costs to reduce defects.
The consultant emphasized that although first-year start-up costs are slightly higher than
subsequent years, management must really view the cost estimates in the table as annual,
ongoing costs. Given employee turnover and the assumption that supplier changes, training,
prevention, and compliance costs are not likely to decline over time, the costs in the
preceding table will be annual operating expenses.
The consulting firm and the newly appointed vice president for quality programs esti-
mated that under level IV, rework and scrap would be $25,000 and warranty costs zero.
Level IV was needed to get the firm to zero defects. A task force was convened, and after
several meetings, it generated the following estimates of rework/scrap and warranty costs
for the various levels of firm commitment:
Total Rework/ Total Warranty Scrap Cost* Costs†
Status quo $500 $350 Level I 300 280 Level II 150 140 Level III 75 80 Level IV 25 0
*The costs of manufacturing scrap and rework. †The costs of repairing and replacing products that fail in the hands of customers.
There was considerable discussion and debate about the quantitative impact of
increased quality on additional sales. Although no hard-and-fast numbers could be
derived, the consensus view was that the total net cash flows (contribution margin) from
Chapter 23 Organizational Architecture and the Process of Management Innovation 23-23
additional sales as retailers and customers learn of the reduced defect rate would be as
follows:
Contribution Margin on Additional Sales
Status quo $ 0 Level I 600 Level II 1,000 Level III 1,200 Level IV 1,300
a. Assuming that the data as presented are reasonably accurate, what should Guest Watches do about its deteriorating quality situation? Should it maintain the status quo or should it adopt the consultant’s recommendation and implement level I, II, III, or IV?
b. Critically evaluate the analysis underlying your policy recommendation in part (a). Will the senior management of the watch division make the same decision as the senior
management of Guest Fashions?
23–3. According to a New York Times article,30 LDS Hospital in Salt Lake City installed a com- puter in every hospital room in the mid-1980s. These computers replaced paper charts so
everything the doctor or nurses did was entered into a database as it happened. A small
number of patients get infections following surgery, which adds to the length of their hospi-
tal stay and ultimately to the cost of treating the patient. After several years, hospital per-
sonnel began using the computerized data to determine the best time to begin antibiotics for
patients undergoing surgery. They found that by starting antibiotics a few hours before
surgery, the rate of infections fell from 1.8 percent to 0.4 percent, saving the hospital about
$9,000 per case. By using the computer system, the head of LDS’s quality control program
can improve quality and cut hospital costs.
Analyze the LDS quality control program in terms of basic TQM principles.
23–4. LDS Hospital in Salt Lake City has a computer system that records all procedures per- formed on patients and all drugs administered.31 The computer system can track which sur-
geons are the best and which ones are the worst in terms of length of patient stays, compli-
cations, and death rates. They found that once a new quality-improvement program was
imposed after an extensive study of past practices, nearly all the doctors improved. But
some did not.
The doctor in charge of the quality-improvement program said, “I have a few bad ap-
ples. And I know who they are. But for quality improvement to work, you have to construct
a ‘safe’ environment where doctors trust you. Any time you start taking names, you’re
going to start a cycle of fear, and quality improvement will not occur.”
When he learned of the LDS tracking system, the head of the Utah medical board said,
“That’s a terrible indictment of them and of the practice of medicine that they are willing to
sacrifice patients to unnecessary mortality, morbidity, injury, and pain by these doctors. It’s
unconscionable!”
Discuss the dilemma LDS faces in terms of using its computer system to improve quality.
23–5. A company chairman was given a ticket for a performance of Schubert’s Unfinished Symphony. Since he was unable to go, he passed the invitation to the company’s quality- assurance manager. The next morning the chairman asked him how he enjoyed it and, instead
of a few plausible observations, he was handed a memorandum which read as follows:
• For a considerable period, the oboe players had nothing to do. Their number should be
reduced, and their work spread over the whole orchestra, thus avoiding peaks of inactivity.
30J. Brinkley (1994), “At Utah Hospital, Innovative Way to Track Medical Quality,” New York Times (March 31), B8.
31J. Brinkley (March 31, 1994).
23-24 Part 4 Applications of Organizational Architecture
• All 12 violins were playing identical notes. This seems unnecessary duplication, and the
staff of this section should be drastically cut. If a large volume of sound is really required,
this could be obtained through the use of an amplifier.
• Much effort was involved in playing the demi-semiquavers. This seems an excessive re-
finement, and it is recommended that all notes should be rounded up to the nearest semi-
quaver. If this were done, it would be possible to use trainees instead of artisans.
• No useful purpose is served by repeating with horns the passage that has already been han-
dled by the strings. If all such redundant passages were eliminated, the concert could be
reduced from 2 hours to 20 minutes.
In light of the above, one can only conclude that had Schubert given attention to these
matters, he probably would have had the time to finish his symphony.
Although the memo obviously was written in jest,32 how would you respond?
32http://www.mcafee.cc/Bin/jokearchive.txt
Index
Aaron, H., 703 ABC network, 147
Abercrombie & Fitch, 281
Ability to trade, 51–52
ABN Amro, 579
Abortion, 687
Abraham, K., 518n
Absolute advantage, 72
Accenture, 637, 643
Accord, 377
Accounting methods,
conservative choices
of, 675
Accounting profit, 197n
Accounting scandals. See Corporate scandals
Across-firm performance, 513
Adams, S., 6
Adelphia Communications, 330,
562, 579
scandal, 8
Advanced Pricing Agreement
(APA) Program, 550
Advance pricing agreements, 665
Adverse selection, 344–347
in insurance market, 344–347
problems, 487n
in used car market, 347
Advertising
ban on cigarettes, 304
Advertising provisions,
637–638
conflicts over, 637
Aeppel, T., 230, 346
Aerospace industry
vertical integration in, 632
Affordable Care Act, 33, 173
Agency costs, 341–343
Agency problems, 340–341
multitask, theoretical research
in, 416
and value maximization, 349
Agency relationship, 340
Agent, 340
Aggregate demand, 53
Aghion, P., 382n, 386
AGT Company, 650–653
Aguayo, R., 531n
Ahold, Royal, 609
Airbus Industries, 259
competition with Boeing,
296–315
Aircraft manufacturers, 296–315
Airline industry
effect of terrorist attack, 137,
296–297
lack of profitability, 173
price wars, 212
pricing in, 128, 208, 247
United Airlines, 201, 208
Air pollution, 661
Akerlof, G., 347n, 450n, 665
Alaska fishing industry, 445
Alaska Pipeline, 202, 622
Albuquerque, A., 512
Alcatel-Alsthom SA, 334
Alchian, A., 5n, 7n, 12, 177n,
201, 524n, 605n, 622n,
627n, 646
Alcoa, 202, 626
Aley, J., 447n
Alibaba.com, 701
Alibaba Group Holding, 701
Allen, F., 590n
Allen, W., 201
Allgyer, Robert, 574
Alt, J., 374, 630n
Alternative dispute resolution
(ADR), 661
Altman, E., 332n
Aluminum prices, 157
Amalgamated Fabric Company,
644
Amazon.com, 158, 249, 262,
289, 308, 333, 616
A.M. Best Company, 700
American Airlines, 208, 212,
247, 297, 333
American auto jobs, 673
American Crop Protection
Association, 671
American Federation of
Teachers, 671
Amul, 306
Anand, G., 695
Andersen, Arthur, 572
Andersen Consulting (AC), 573
Andersen Worldwide (AW), 573
Anderson, E., 630n
Angwin, J., 392
Annin & Company, 137
Annual performance reviews, 514
AnswerThink Consulting Group, 551
Antitrust, 136n
Apple Computer, 247
and cooperation by firms, 266
and monopoly, 206n
Robinson–Patman Act, 247
Antitrust law
and price-discrimination, 626
Antitrust legislation, 657
Aoki, M., 448, 465, 526n
Apple computer, 138, 281, 361,
377, 615–616, 618, 634,
644–645
antitrust case, 247
iTunes pricing, 248–249
pricing of iPhones, 246
Apple Inc., 139, 550
Arbitrage-trading, 11
Arbittier, Lauren, 41
Arc elasticity, 125, 126
Archer Daniels Midland
Corporation (ADM), 217
Architectural determinants,
360–366
changing architecture, 364
interdependencies and
complementarities
within organization,
365–366
Armour, S., 90
Armstrong, L., 376n
Arnold, E., 445
Arrow, K., 5n, 395n, 407n, 705,
705n
Arthur Andersen LLP, 47,
579, 598
demise of, 576
early years, 572
Enron and, 575–576
entery in consulting business,
572–573
family feud, 573
moves into twenty-first
century, 574–575
organizational changes,
573–574
overview, 571–572
strategic changes, 573–574
Aspartame, 317
ASPCA code, 697
Assembled knowledge, 99–100
Asset abuse, renting and, 629
Asset ownership, 632–633
Assets
firm-specific. See Firm- specific assets
specific. See Specific assets Asymmetric information
and agency problems,
340–341
categories, 487n
in contract negotiations,
343–347
and costly contracting,
338–339
postcontractual, 487n
precontractual, 487
transfer pricing with,
552–556
Atkins Diet, 199
Atlanta school district, 491
Atlantic Water Trust, 2
AT&T, 194, 246, 281, 360, 362,
548, 578, 626–627
Attorneys general (AGs), 670
AT&T Wireless, 212
Auditing, 317
Audretsch, D., 604n
Aumann, Robert, 298
Auriemma, A., 383
AutoCorp, 627–641, 644
AutoMart Company,
379–409
organizational structure,
379–380
715
Page numbers followed by n indicate material found in notes.
716 Index
Automobile industry
in consumer credit business,
283–284
reaction to steel prices,
167–168
rebates, 242n
steel use in, 156–157
in United States, 8
Auto-parts industry
price fixing in, 315
Average cost curve, 169, 170
Average fixed cost, 172,
173–174
Average product, 159–160
Average total cost, 172, 174
Average variable cost, 172, 174,
196, 629
Axioms of choice, 20n
Azurix Corporation, 2
Baber, W., 424n Baby Bells, 360, 362
Backward induction,
311–312
Backward integration, 618
Bagby Copy Company,
431–432
Baier, K., 689n
Bailey, F., 176
Baily, M., 510
Baker, G., 453n, 486n, 489n,
495, 509n
Balfour, F., 660
Banc One, 231
Bank, D., 421, 655n
Bank of America, 457
Bank of America Securities, 696
Bankruptcy
at Enron, 2
of Polaroid, 282
of WorldCom, 14, 579
Banks
customer profitability in, 17
Barbarians at the Gate (Burrough & Helyar),
329
Barbaro, M., 281
Barboza, D., 696
Barclays, 369
Bargaining failures, 343–344
Barnes, A., 525n
Barnes & Noble, 308
Barney, J., 272n, 285n, 286n
Baron, Ron, 588
Baron Capital Group, 588
Barra, Mary, 383, 687
Barrett, A., 662
Barriers to entry, 201–204
exit costs, 204
incumbent advantages,
203–204
incumbent reactions, 201–203
and market power, 270
and profit potential, 270
reputation effects, 202–203
Barron, K., 261
Barry, V., 712
Barzel, Y., 5n, 508
Baseball batting averages, 162
Basic competitive pay level
model, 441–442
Baumol, William, 141n
Bayer AG, 246
Beautiful Mind, 298 Bebchuk, Lucian, 588, 589n,
597n, 597
Beck, E., 676
Becker, B., 453n
Becker, E., 678
Becker, Gary S., 28n, 35n, 43,
443n, 450, 465, 697
Been, Ed, 609
Behavioral economics, 37–38.
See also Economic behavior
purpose of model, 38
realistic assumptions in, 38
Behaviors, 687
Beijing Olympics of 2008, 156
Beilson, N., 698n
Benchmarking, 8, 372–373
and economic Darwinism, 7–9
external, 513
Lincoln Electric Company,
372
for performance evaluation,
505–507
Bennett, J., 687
Bennhold, Katrin, 12
Berensen, Alex, 32
Berg, N., 502n
Berger, P., 621n
Berkshire Hathaway, 281
Berle, Adolf, Jr., 335n, 582
Berndt, E., 159n
Bernstein, A., 183
Bertrand model, 212n
Besanko, D., 293, 617n
Best Buy, 233
Beyond.com, 237
Bhagat, S., 659n
Bidding, 684–685
Big-Bang Disrupter, 361
BioChem, 635
Biometric systems, 137
Bisoux, T., 607n
Bittlingmayer, G., 679
Blackberry, 616
Blair, R., 639
Blankfein, Lloyd, 441
Blattberg, R., 242n
Blazar, E., 531n
Blinder, A., 491
Blockholders, 581, 590, 591
Block pricing, 232–233
as menu pricing, 239
Blu-ray players, 136
BMW, 428
Board of directors, 591–594
authority of board, 400,
591–593
board member incentives,
593–594
Bobby’s Burgers, 483
Body art, 457
Body piercings, 457
BodyWorks, 629, 632
Boeing Company, 258, 643
competition with Airbus,
296–315
Bognanno, M., 453n
Bolch, M., 396
Bollingtoft, A., 426n
Bolton, P., 380n, 382, 386, 404,
416, 434
Bomb-detection systems, 137
Bonding costs, 340
“Bonding” mechanism, 598
Book prices, 237
Books-a-Million, 289
Book-selling industry, 308
Bootleggers and Baptists
Phenomenon, 678
Borders Books, 308
Boston Market, 283
Bounded rationality, 16n
Bouton, Daniel, 11
Boyd, E., 401
Boyer, Jeff, 687
Brabantia, 355–356, 358, 365
Bradshe, K., 615n
Brandenburger, A., 263n,
293, 318
Brand loyalty
and price elasticities, 128
Brands, experience goods, 204
Brandt, R., 689n
Brazil
deregulation of airfares in,
674
Bremner, B., 450, 690
Brickley, J., 5n, 106, 286n, 305,
370n, 400, 473n, 549n,
590n, 594n, 634, 636,
638n, 639, 659n, 684,
694n, 701n
Bridgestone Corporation, 315
Briggs & Stratton, 537–539,
544, 548, 549
British Airways, 509
British Food Standards
Agency, 697
British Petroleum (BP),
274–276
British Serious Fraud
Office, 336
Broad task assignment
versus specialized, 411–415 Delta Airlines versus China
Eastern Airlines, 414
Brooker, K., 438n
Brown, E., 137, 138
Brown, K., 571n
Bruns, W., 518n, 562n
Bryant, A., 296n
Bryn Mawr College, 124
Buckman, R., 231
Budget constraint, 53
with income change, 23, 24
opportunity cost, 22–23
with price change, 23, 24
Budget line, 22
equation, 51
inter-temporal, 62–63
and optimal consumption
bundle, 51–52
and price increase, 54
Buick, 544
Bundling. See Product bundling Burberry PLC, 701
Bureaucracy
and decentralized decision
making, 389
Burger King, 267, 624, 696
Burlington Industries, 677
Burns, J., 445
Burrough, B., 329
Burrows, P., 655n
Bush, George W., 571n, 643
Business environment, 423–424
constantly evolving, 280–282
firm’s understanding of,
286–287
government regulation,
286–287
markets, 286
technology in, 286–287
Business ethics, 685, 686.
See also Ethics and organizational
architecture, 688
Business judgment rule, 592
Business model, Enron
Corporation, 1–2
Business norms, 697
Business process reengineering,
268
Business segments, Enron
Corporation, 1–2
Business strategy, 7, 258n. See also Strategy
BusinessWeek, 2 Buttross, T., 501
Buyer power, 270, 271,
272, 287
Buyer-supplier conflicts, 334
Byrd, J., 594n
Cable television, 146 Cable TV, 193–194
CAC stock market index, 11
California blackouts, 2
Campbell, D., 142n
Campbell Soup Company, 18
Canon, 277, 297
Cantalupo, Jim, 283
Capital goods, two-part tariff
for, 235
Car and Driver magazine, 377 Card, D., 94n
Cardinal ranking, 49
Careers and lifetime pay,
449–454
efficiency wages,
449–450
job seniority, 451–452
at Mitsubishi, 450
promotions, 452–454
Carey, S., 86, 173, 414
Cargill, 396, 580
Carlton, D., 214n, 624n, 627n,
642n, 646
Carr, Peter, 698n
Cartels, 215–217
Cartels’ dilemma, 215–216
Case Corp., 551
Casey, Walter, 231
Cash flows, expected, 115
Caterpillar, 616, 644
Cauchi, M., 428
CBS network, 147, 305
Cell phone companies, 239,
240, 241
price wars, 212
Celtex, 563
Cendant Corporation
massive financial fraud, 562
Center for Auto Safety, 687
Central Bank of Greece, 696
Central information, use of,
384–385
Centralization. See also Decision rights
advantages, 391
versus decentralization, 380–393
of decision rights, 377
multinational companies, 384
R&D on return on investment
and, 391
Central planning
versus market economy, 98–101
Central tendency, 39
Century 21 International, 359
CEO magazine, 593 CEO turnover, 106
Certainty equivalent, 40–41
CFO Magazine, 2n Chambers, John, 443 Champix
and cigarettes, cross elasticity
between, 133
Chandler, A. Jr., 105, 423n, 424n,
434, 624n
Chandler, C., 376n
Change
in business environment, 281
in demand, 123
in the quantity demanded, 123
Chantix, 133
Charge-back systems, 549
Charles Schwab Corporation, 589
Charter Communications, 194
Chase Blueprint, 31
Chavez, Hugo, 70
Chemical processing industry,
178
Chesebrough, Robert, 245
Cheung, S., 5n, 557n
Chevrolet, 383, 544
Chew, D. Jr., 612
Chiang, J., 159n
Chief executive officer (CEO),
400
authority of, 592–593
debate over compensation
of, 492
fired at Hewlett-Packard, 594
firing, and inappropriate
architecture, 370
incentives, 593–594, 597–598
postretirement incentives, 605
as top management authority,
594–597
view of verbal contracts, 703
Chief financial officer (CFO),
595–596
Chief operating officer
(COO), 595
China
counterfeit products in, 660
demand for steel, 156
gross domestic products, 66
pollution levels, 181
pork prices, 183
textile industry, 271
toy factory, 390
transferring organizational
architecture to, 10
China Eastern Airlines, 414
Chinese agriculture, 490
Chipotle Mexican Grill, 283
Chiu, J., 701
Choe, C., 551
Choice-of-effort conflict, 332
Choice(s)
continuum of, 634–635
and ethics, 687–688
Christie, A., 595n
Christie’s International PLC, 588
Chrysler Corporation, 8
Chu, K., 701
Cigarette advertising ban, 304
Cigarettes
Champix and, cross elasticity
between, 133
Circle technique, 302, 316
Cisco Systems Inc., 368, 443,
501, 643
Citibank, 685, 697
Citibank Argentina, 707
Citigroup, 369, 422, 579, 685
Civil law countries, 590n
Clapton, Eric, 43, 44
Clarion Hotel, 167
Clorox, 419
Closely held corporations, 580
Close substitutes, 195n
Coalition, formation of,
670–671
Coalition for Asbestos
Resolution, 671
Coalition formation, 678–678
Coase, Ronald, 5n, 95n, 96, 102,
102n, 105, 107, 333,
447n, 557n, 621, 621n
Coase Theorem, 95–98, 661
contracting costs, 97
and externalities, 95–98
Cobb-Douglas production
function, 158n
Coca-Cola Company, 7–8, 272,
297, 548, 580, 691
Cochran, T., 704n, 711
Codes of conduct, 685
Codes of ethics, 704–709. See also Ethics
altering preferences, 705–706
corporate culture, 709
education, 706–709
Cohen, A., 340
Coke, 132, 317, 318
Colchester, M., 369
Coles, J., 5n, 400, 594n, 659n
Collective-action problems, 395
Collective decision making,
395, 407–409
example of majority voting,
407–409
managerial decisions, 409
College tuition, 124
Collins, J., 692n
Collis, D., 272n, 277, 293
Collusion, 210, 211
in Lysine industry, 217
Colombia
property rights insecurity in,
70
Colombo, M., 595n
Comcast, 562
Comment, R., 285n, 621n
Commercial Banks
and prepay transactions, 599
Commercial litigation, in United
States, 659
Common law countries,
590
Common stock, 115
demand curve for, 143
Common transfer pricing
methods
full-cost, 559
marginal-cost, 557–558
market-based, 556–557
negotiated, 559–560
Commonwealth of Puerto Rico,
671
Communication
and corporate culture, 367
within firms, 382
Compaq, 669
Compaq Computers, 400, 594
Comparative advantage,
71–74
specialized task assignment,
412
Compensating differentials,
444–446, 505
Alaska fishing industry, 445
job requirement variations, 444
unpleasant jobs, 445
Compensation. See also Incentive compensation
CEOs’, 512
compensating differential,
505
cruise line, 456
fringe benefits, 455. See also Fringe benefits
labor market, 441–442
and performance evaluation,
505
related to stock analyst
choices, 29, 30
and risk aversion, 41
Compensation plan
change in, EVA and, 548
Index 717
Compensation plans
contracting objectives, 440
only-money-matters model,
33
pay level, 441–446
piecework basis, 349–350
structuring, 463
Competition
for cable TV, 194
degree of rivalry, 271
determinant of price
elasticities, 127–128
and economic Darwinism, 7
global, 391
identifiable rivals, 259
and minimum efficient scale,
175, 176
and number of competitors,
272
and organizational change, 9
product market, 371
in textile industry, 271
and transportation costs,
175–176
Walmart vs. Amazon, 289 Competition vs. coordination,
303–305
Competitive advantage of new
firms, 141
Competitive equilibrium,
197–200, 620
constant versus increasing cost industries, 199–200
strategic considerations, 200
Competitive industries vs. market power, 270
Competitive labor market,
441–442
Competitive markets, 76
basic conditions, 195
benefits of buying in,
620–621
efficiency in, 90
example, 195
firm supply, 195–197
market prices, 197
price takers, 195
shutdown condition, 196
Competitive pressures, 280
Competitors, 271, 272
reaction to pricing policy,
246–247
vertical integration to avoid
contracting with, 634
Complements
in corporate culture,
368–370
effect on demand, 131–132
and organizational policies,
365–366
price of, 263–265
reason for diversification,
283–284
Complete contract, 628
Computer models, decentralized
decision making, 392
Conflict
incentive, 602
Congressional Budget Office
(CBO), 33, 95
Conlin, M., 509
Conrad, D., 503
Conservation of management
time, 381
Conservative choices, of
accounting methods, 675
Constant-cost industry
versus increasing cost industry, 199–200
Constant growth model,
115–116
Constantinides, G., 492
Constant returns to scale, 158
Constraints and opportunities,
22–23, 24
Consumer choice, 27
ability to trade, 51–52
budget line, 51
calculus for equal marginal
principle, 59–60
corner solution, 59
demand functions, 53–54
equal marginal principle, 52
income effect, 54–57
interior solutions, 59
and inter-temporal
consumption decisions,
61–65
magnitude of substitution
effect, 57–59
and managerial decisions, 60
marginal rate of substitution,
51
marginal utility, 49–50
marginal utility of income, 53
optimal consumption bundle,
52–53
slope of indifference curves,
50–51
substitution effect, 54–57
utility maximization, 52
Consumer credit business,
283–284
Consumer demand
heterogeneous, 234–242
homogeneous, 232–234
personalized pricing, 236
price discrimination in,
234–235
Consumer electronics, 203
Consumer Reports, 349, 700 Consumers
budget constraint, 53
understanding wants of, 139
Consumers budgets, 128
Consumer spending, decline in
2007, 281
Consumer surplus, 90–91, 658n
and pricing policy, 224
in value, 260
Consumer surveys, 139, 142
Consumer transaction costs,
261–262
components of, 259
and Global Entry Program of
U.S. government, 262
reduced by Internet, 262
reduced to create value,
261–262
Consumer waiting time, 261
Consumption
and budget constraint, 22–23
of pork per capita, 183
Consumption bundle
indifference curves, 50–51
marginal utility, 49–50
optimal, 52–53
utility functions, 49
Consumption choice
inter-temporal, 62
optimal, 63
“Container Principle,” 158
Contract compliance, 348–349
Contracting costs, 97
ethics and policy
implementation,
702–704
and existence of firms,
101–106
within firms, 103–106
incentives to economize on,
349–350
in markets, 102–103
minimizing, 333
and nonmarket transactions,
621–624
controlling externalities, 624
extensive coordination, 624
firm-specific assets,
622–623
measuring quality, 623
reduced by Ford and General
Motors, 283–284
Contracting objectives, 440–441
Contracting with competitors,
vertical integration to
avoid, 634
Contracting with distributors,
636–642
double markups, 638–641
free-rider problems, 636–638
oil industry distribution
systems, 642
regulatory issues, 641–642
Contract negotiations,
asymmetric information
in, 343–347
Contracts. See also Long-term contracts
complete, 628
to control incentive conflicts,
334–347
costless contracting, 335–338
costly contracting, 338–339
defining organizational
architecture, 335
distribution of residual
profits, 333
duration, 635–636
economic determinants of,
636
explicit, 331
within firms, 331–332, 333
implicit, 331–332
incentive, 476–489
group incentive pay,
483–485
incentive pay, 481, 486
information revelation, 487
informativeness principle,
482–483
multitasking, 485–486
optimal contract, 479–480
principal-agent model,
476–481
relative performance
contract, 482
selection effects, 488–489
incomplete, 628
postcontractual information
problems, 340–343
precontractual information
problems, 343–347
Control/control system
architecture within firms, 359
new technology and, 362
ownership and, separation of
incentive issues, 582–583
publicly traded
corporations, 583–584
survival of corporations,
583
Convex to the origin, 22,
57–58
Conyon, M., 453n
Cook, D., 562
Cook, Tim, 276
Coolidge, A., 263
Cooper, Cynthia, 596
Cooper, H., 657
718 Index
Cooperation
and antitrust laws, 266
in Cartels, 216
to increase value, 265–266
meet-the-competition clauses,
216–217
most-favored-nation clauses,
216
and prisoners’ dilemma,
214–216
and teammates’ dilemma,
326–327
Cooperative equilibrium, 315
Cooperative games, 298n
Coordination
versus competition, 303–305
extensive, 624
problems with HDTV, 305
Coordination/competition game,
306
Coordination costs
and decentralization failures,
384
specialized task assignment,
413
Coordination game, 304
Copper Box Company, 553
Copyrighted items, Supreme
Court rules in favor of
selling imports of, 235
Core, J., 593n
Core competencies, 633
Corkery, Michael, 6
Corner solution, 59
Corn prices, 183
Coronas, José, 69
Corporate control, market for,
604–605
Corporate culture, 366
codes of ethics, 709
and communication, 367
complements, 368–370
and employee expectations,
368
European banks, 369
at Netflix, 367
value of, 369
Corporate ethics programs, 686
Corporate giving, do’s and
don’ts of, 694
Corporate governance, 578–612.
See also Corporate scandals
alternative systems objectives,
582
described, 579
growth in lead directors, 8
historical perspective,
608–610
international, 601–604
market forces, 604–606
organizational architecture,
584–585
board of directors, 591–594
decision rights, 585–586
external monitors, 598–601
shareholders, 586–591
top management, 594–598
publicly traded corporations,
580–582
corporate form of
organization, 580
governance objectives, 582
stock exchanges, 581
stock ownership patterns,
581
Sarbanes-Oxley Act of 2002,
606–608
separation of ownership and
control
incentive issues, 582–583
publicly traded
corporations, 583–584
survival of corporations,
583
Corporate organization
critical aspects of, 4
at Enron, 2–3
prescriptions for
improvement, 3
Corporate philanthropy
taxes and, 692
Corporate policy setting,
695–698
business norms, 697
diversity of input, 696
legal standards, 696–697
press standard, 697
Corporate scandals, 608–610
Adelphia, 8
Enron Corporation, 1–3
Olympus Corporation, 336
Tyco, 8, 609
WorldCom, 8, 606
Corporate social responsibility,
685, 692–693
Friedman’s view of, 694
Corporate strategy, 258n. See also Strategy
Corporations
closely held, 580
publicly traded, 580–582
benefits of, 583–584
corporate form of
organization, 580
governance objectives, 582
stock exchanges, 581
stock ownership patterns,
581
survival of, 583
Cost-benefit analysis, 16–18
Cost centers, 539–542
summary of, 547 Costco, 235
Costco Wholesale Corporation,
258, 281
Cost curves
average cost curve, 169, 170
in competitive markets, 197,
198
in decision making, 185
marginal cost curve, 169, 170
in monopolistic competition,
207
and opportunity costs, 171
and production functions, 170
short- vs. long-run, 171–175 total cost curve, 169, 170, 172
unit cost, 169
U-shaped, 170
Cost estimation, 184–185
Costless contracting, 335–338
Costless information
transfer pricing with,
551–552
Costly contracting, and
asymmetric information,
338–339
Cost minimization, 165–166,
166n
contracting costs, 333
and marginal product-price
ratio, 170
Cost of protection, 673
Cost-plus pricing, 185, 228–229
Costs
of decentralization
central information use,
384–385
coordination costs and
failures, 384
incentive problems,
382–384
of decentralized decision
making
central information use,
384–385
coordination costs and
failures, 384
General Motors, 383
incentive problems,
382–384
of diversification, 284
Cost(s)
of coupon/rebate programs,
242
of exit, 204
explicit, 18
implicit, 18
incremental, 16
of internal labor markets,
448–449
of performance measurement,
508
of specialized task
assignment, 412–413
sunk, 17
Costs of production
cost curves, 169–171
economies of scale, 177
economies of scope, 178–179
estimating, 184–185
fixed, 172
historical, 171
for hog producers, 183
and learning curves, 177–178
long-run, 184
minimum efficient scale,
175–177
and plant location, 181
reduced to create value, 261
relevant, 171
short-run, 184
variable, 172
Cotton gin, 270
Counterfeiting, multinational,
660
Counterfeit products, 660
Coupons, 241–242
Cournot, Augustine, 210
Cournot equilibrium, 210, 211
Cournot model, 210–211
Courts, enforcement of property
rights by, 658
CPA exam, 160
Crawford, R., 622n, 627n, 646
Crawford, V., 382
Creativity, 18–20
Credibility, 312–313
Credit markets, 700
Criminal behavior, 36
Cross-country differences in
accounting, 270n
Cross elasticities in antitrust,
136n
Cross elasticity of demand,
132–133
estimates of, 133
Cruise line compensation, 456
Crum and Foster, 286
Cruz, Roberto (Bob), 379–380
CSX, 548
Culture, effect on economic
behavior, 34
Cumulative production,
177–178
Curl, J., 678
Customer goodwill, 245
Customer profitability, 17
Index 719
Cutler, S. M., 600
CVS, 173
Cypress Systems, 217
Dahlman, C., 97n Daimler Benz, 580
Daimler Chrysler, 643
D’Allegro, J., 20n
Damon, Matt, 217
Dark, F., 473n, 639, 701n Darwin, Charles, 7
Darwin’s theory of natural
selection, 371
Datar, S., 514n
Davis, B., 643
Davis, D., 301
DAX stock market index, 11
Deadweight loss
in lost gains from trade, 206n
Debt financing at Enron, 2
Decentralization, 377. See also Decision rights
benefits of, 380–382
effective use of local
knowledge, 380–381
management time
conservation, 381
training and motivation for
local managers, 381–382
and bureaucracy, 389
Cargill, 396
versus centralization, 380–393
trade-offs between, 385–389
costs of
central information use,
384–385
coordination costs and
failures, 384
General Motors, 383
incentive problems,
382–384
decision rights, 377
and global supply chain, 390
at Google, 381
management implications
across firms, 389–391
recent trends, 391–393
multinational companies, 384
technology and, 391–393
Decentralized decision making,
100, 359
benefits of, 380–382
effective use of local
knowledge, 380–381
management time
conservation, 381
training and motivation for
local managers, 381–382
and bureaucracy, 389
versus centralized, trade-offs between, 385–389
computer models, 392
costs of
central information use,
384–385
coordination costs and
failures, 384
General Motors, 383
incentive problems,
382–384
management implications
across firms, 389–391
recent trends, 391–393
theoretical research in, 386
Decentralized firm, 554
Decentralized M form
organization, 431
Dechow, P., 5
Decision authority, 378
of shareholders, 586–590
Decision control, 397–399, 561
and decision management
separation of, 397–398,
399, 400, 401
trade-offs between, 561–564
definition, 397
Decision making, 561. See also Managerial decisions
and bureaucracy, 389
centralization of, 377
collective, 407–409
decentralized. See Decentralized decision
making
decision control, 561
decision management, 561
with economic choice, 16, 17
within firms, 330, 376
with game theory, 297–298
at Honda, 376–377
implementation, 397
initiation, 397
inter-temporal consumption,
61–63
on investments, 206
marginal analysis for, 16–18
and market environment, 194
money vs. integrity in, 28–30 monitoring, 397
in oligopoly, 208
opportunity costs in, 18
ownership and control,
separation of
incentive issues, 582–583
publicly traded
corporations, 583–584
survival of corporations,
583
on pricing, 120, 206
ratification, 397
role of cost curves, 185
and size of firm, 103–104
specific knowledge for, 100
team. See Team decision making
theoretical research, 386
under uncertainty, 38–41
using economic behavior
models, 35–37
Decision management, 397–399
decision control and
separation of, 397–398,
399, 400, 401
trade-offs between,
561–564
definition, 397
Decision nodes, 311
Decision rights, 4, 10, 410–437.
See also Managerial decisions
architecture within firms, 358
assigning tasks and, 378–380
assignment and knowledge
creation, 399–400
assignment to teams, 394–396
centralization versus decentralization,
380–393
collective decision making,
407–409
decision control, 397–399
decision management,
397–399
functional managers,
436–437
influence costs, 401–403
jobs building into subunits,
416–417
environment, strategy, and
architecture, 423–424
functional and product or
geographic subunits,
trade-offs between,
420–423
grouping, by function,
417–418
grouping by function,
417–419
grouping by product or
geography, 419–420
matrix organizations,
424–426
mixed designs, 426
network organizations, 426
organizing within subunits,
426
lateral issues, 393
and performance metrics, 543
productive bundling of tasks,
415–416
recent trends in assignments
of, 427–431
Sarbanes-Oxley Act of 2002
and, 586
and scientific management,
41
sources of, 585–586
specialized versus broad task assignment, 411–415
Time Inc., 401–411
Decline stage, 140–141
Decreasing returns to scale, 159
Dedicated assets, 623
Defense budget, 137
Defense Contract Audit Agency,
334
Degree of rivalry, 271
360-degree performance
reviews, 516
Delaware General Corporation
Law (the “DGCL”), 589
Dell, Michael, 100
Dell Computers, 100, 203, 265,
421, 616, 618, 643, 669
Delmastro, M., 595n
Delta Air Lines, 212, 247, 297
Delta Airlines, 414
Demand
derived, 131
distribution of, and price
discrimination, 239–242
effect of shift in, 77
effect of store layout, 138
elastic, 127
future prospects, 244–245
industry vs. firm, 135–136 inelastic, 127
influence of income, 133–135
manager knowledge about,
121
marginal revenue and,
154–155
means of increasing
by capturing value,
269–282
Gillette’s strategy, 263
new products/services, 265
price of complements,
263–265
price of substitutes, 265
product quality, 263
by reducing transaction
costs, 261–262
by value creation, 259–269
and network effects, 136–138
point elasticities, 125n, 154
and price of related products,
131, 132–133
720 Index
and product attributes,
138–139
and product life cycle,
139–141
for prostitutes in United
States, 140
relation to prices, 120–121
unitary, 127
Demand curve, 121–131
for common stock, 143
definition, 121–123
derived, 55
for duopoly, 210
and elasticity of demand,
124–128
for factors of production,
180–183
firm-level, 121n
law of demand, 123
linear, 129–131
and market power, 224–225
market power vs. competitive markets, 269
movement along, 123
in perfect competition, 196
perfectly elastic, 83–85
perfectly inelastic, 83–85
and price mechanism, 76
and price sensitivity, 227
for products, 232–233
relatively more elastic, 83
relatively more inelastic, 83
shift factors, 123
shifts after 9/11, 137
and value creation, 259–260
Demand estimation, 141–147
for common stock, 143
implications for managers, 146
by interviews, 141–142
by price experiments, 142–143
by statistical analysis, 143–145
Demand for regulation, 669
Demand functions, 53–54
definition, 121
dependent/independent
variables, 121
example of, 121–122
for industries, 135–136
log-linear, 155
Deming, W. Edwards, 368, 489
Demsetz, H., 5n, 524n, 564n,
581n
Deng Xiaoping, 490
Department of Agriculture, 183
Department of Labor, 596
Dependent variables, 121
Derivative securities, 1
Derived demand, 131
Derived demand curve, 55
Descriptive analysis, 687
Dessein, W., 382, 386
Dessein’s model, 382
Determinants, architectural,
360–366
changing architecture, 364
interdependencies and
complementarities
within organization,
365–366
Deutsche Bank, 369, 440
Dewatripont, M., 380n, 382,
386, 404, 416, 434
Diamond, D., 599n
Diet Coke, 317
Differential horizons, 333
Differential risk exposure,
332–333
Differentials, compensating, 691
Dinopoulos, E., 673
Direct costs of regulations, 662
Direct-market tests, 142
Direct-serve gasoline stations,
642
DirecTV, 146, 193–194
Disclosure, 701
Discounting, 63, 115
Discount-variety stores, 258
Dish Network, 194
Disney Corporation, 285
Disneyland, 233
DisposeCo, 691
Distributors, contracting with,
636–642
double markups, 638–641
free-rider problems, 636–638
oil industry distribution
systems, 642
regulatory issues, 641–642
Ditlow, Clarence, 687
Diversification, 41
benefits of, 282–284
costs of, 284
at McDonald’s, 283
problems at Xerox, 286
and reduced earnings
volatility, 284–285
related, 284–285
and value maximization, 282
by Walmart, 283
Dividends, 115, 116
Divisional performance
cost centers, 539–542
expense centers, 542–543
investment centers, 544–548
profit centers, 544
revenue centers, 543
Dixit, A., 219, 307n, 320
Doctors, perverse incentives
from Medicare, 32
Dodd-Frank Act of 2010, 400
Doeringer, P., 465
Dog stylist, 135
Dominant strategy, 214,
300–301, 314–315
and Nash equilibrium,
301–302
Donaldson, Mary, 61–63
Donaldson, T., 711
Donatos Pizza, 283
Dopp, Darren, 422
Dore, R., 448
Double markups
contracting with distributors,
638–641
example, 638–641
quotas, 641
two-part pricing, 641
Dow, 400
Downstream integration, 618
Drago, R., 453n
Dranove, D., 293, 617n
DrugCo, 624–626
Drug companies, 32
Drugmakers, 695
Drugstores, 300
3-D television sets, 136
Dual transfer pricing systems,
551
Dubner, S., 344
Dugan, I. J., 571n
Duhigg, C., 615n
Dulaney, R., 202n
Dumaine, B., 648n
Dun & Bradstreet, 700
Duncan, David, 576
Duopoly, 209–210
DuPont, 423, 469–470, 619
group performance, 483
principal-agent model, 481
Dutch civil law, 590n
Dutch State Mines, 317
Duvick, Todd, 696
DVD players, 131
Dvorak, J., 513
Dvorak, P., 203
Dworkin, T., 525n
Dylan, Bob, 43, 44
Dysfunctional behaviors, 507
Earnings volatility, 284 Earwell, J., 107
Easterbrook, F., 589n
Eastman Kodak, 281, 363, 370
Eaton, 548
eBay, 75, 235, 350, 701
and network effects, 138
Ebbers, Bernard “Bernie,”
578–579, 606
e-books, 308
Eccles, R., 566
Eckbo, B., 370n
Economic analysis
ack of preference-based
explanations, 27
of behavior, 28–30
and behavioral economics, 38
of consumer choice, 49–60
of criminal behavior, 36
for decision making, 5–7
Fisher Separation Theorem,
64–65
graphical tools for, 20–27
and individual incentives, 4
and inter-temporal decisions,
61–65
managerial implications,
30–32
marginal analysis, 16–18
and organizational
architecture, 5
and organizational design, 5
for organizational design,
4–5
pricing policy, 4
study of trade-offs, 33
Economic behavior. See also Behavioral economics
alternative models, 32–35
criminal activities, 36
economic choice in, 15–16
effect of culture on, 34
individual constraints, 18–20
managerial use of models,
35–37
marginal analysis for, 16–18
money vs. integrity in, 28–30 opportunity costs in, 18
1997 Economic Census reports,
580
Economic choice, 15–16
Economic costs
of Sarbanes-Oxley Act, 607
Economic Darwinism
and benchmarking, 7–9
business strategy, 7
and competition, 7
ethics and, 690
growth in lead directors, 8
managerial implications, 9
and organizational
architecture, 7
and organizational change, 9
principle of, 583
Economic determinants, of
contact duration, 636
Economic incentives
versus happy-is-productive model, 33
ObamaCare, 33
Index 721
Economic incentives in
subprime mortgage
crisis, 6
Economic motives, for
government intervention,
658–668
defining and enforcing
property rights, 658–660
redistributing wealth,
666–668
redressing market failures,
660–666
Economic profit, 197–200
market power vs. competitive markets, 269
without market power, 280
zero, 207–208
Economic profits, 546
Economics, defined, 687
Economic systems
basic issues confronting,
67–68
central planning versus market economy, 98–101
central planning vs. free markets, 67–68
contracting costs and firms,
101–106
externalities and Coase
theorem, 95–98
gains from trade, 69–75,
90–91
goals of, 67–68
linear supply and demand,
80–82
managerial decisions, 106
price mechanism, 76–78
prices as social coordinators,
82
property rights, 68–75
qualitative forecasts,
79–80
shifts in curve versus movements along
curves, 79
specific knowledge in, 100
Economic theory of regulation,
668–675
Economic trade-offs, 411
Economic Value Added, 538,
546
change in compensation plan,
548
Economies of scale, 177
as barrier to entry, 202
versus economies of scope, 178
versus learning effects, 178 at Proton Holdings, 176
in public utilities, 175
Economies of scope, 178–179
and diversification, 282–283
managerial misconception,
179
Edmonson, Amy, 524
EDS, 637, 643
Education
codes of ethics, 706–709
Efficiency wages, 449–450
Efficient markets hypothesis,
116–117
Effort choice, 534
Ehrbar, A., 691
Ehrenberg, R., 444n, 453n, 465
Ehrlich, Isaac, 36
Eichenwald, K., 217
Elastic demand, 127
Elasticity of demand, 83
airline pricing, 128
arc elasticity, 125, 126
for common stock, 143
determination of price
elasticities, 127–128
for gasoline, 138
for grocery products and
Walmart supercenters,
125
and increasing cost, 89
marginal revenue and,
154–155
and market power, 227
point elasticities, 125n, 154
price changes and total
revenue, 127
price elasticity of demand,
125–126
range of price elasticities,
125, 126
varying along demand curve,
125, 126
Ellison, S., 121n
Elmer, D., 335
EMCOR, 618
EMI Group, 249
Emission Standards, 680
Employee buy-in, 394–395
Employee compensation,
504–505
Employee expectations
and corporate culture, 368
Employee risk, minimizing,
534–535
Employees
conflicts over health
insurance, 346
dysfunctional behaviors, 507
effort problem, 477–479
ethics monitoring, 686
fringe benefits to attract,
461–462
improving communications,
368
learning attributes, 448
motivation, 448
performance evaluation,
reasons for, 504
preferences in salary–fringe
benefit mix, 455–457
reservation utilities, 440
self-evaluation by, 515
shirking by, 504–505
well-connected, 368
Employer, 457
Employment, effect of
minimum wage, 167
Empowerment, 372, 398
Enron Corporation, 7, 41, 371,
571, 579, 589, 592, 702
and Arthur Andersen, 575n
bankruptcy filing, 2
business model, 1–2
business segments, 1–2
financing of expansion, 2
growth in lead directors, 8
origin of problems, 2
partnerships, 2
revenues, 1
Entry
in consumer electronics, 203
limited by government, 203
in monopolistic competition,
207
Entry decision, 212
Envelope of short-run average
cost curves, 174, 184
Environmental analysis,
287–288
Environmental Protection
Agency (EPA), 657
Epstein, A., 503
Equal employment opportunity
(EEO), 525
Equal marginal principle, 52, 53
calculus derivation of, 59–60
Equifax, 548
Equilibrium, 6–7. See also Nash equilibrium
competitive, 197–200
Cournot equilibrium, 210,
211
mixed-strategy, 316, 317
possible, 216n
and price mechanism, 76
pure strategy, 316
in repeated interaction, 315
Equilibrium price
and equilibrium quantity,
81, 82
and price mechanism, 76
Equilibrium quantity, 81, 82
Equilibrium regulated price, 673
Equilibrium strategy, 312
Equitable Insurance, 694
Erickson, M., 333, 459n,
550n, 626n
Ethanol, 183, 279
effect on pork prices, 81
Ethical behaviors
mechanisms for encouraging,
698–702
disclosure, 701
ownership structure,
701–702
repeat sales, 699–700
third-party monitors, 700
warranties, 700
Ethical relativism, 689
Ethics, 685. See also Codes of ethics
and behaviors, 687
and choices, 687–688
codes of ethics, 704–709
altering preferences,
705–706
corporate culture, 709
education, 706–709
and corporate policy setting,
695–698
and corporate social
responsibility, 692–693
and economists’ view of
social responsibility,
693–695
employee monitoring, 686
ethical behavior, mechanisms
for encouraging,
698–702
five arguments, 686
guidelines and training
programs, 686
meanings, 686
normative, 687
and policy implementation,
702–704
and policy setting, 687
Ten Commandments, 687
theories, 689
and value maximization,
690–692
compensating differentials,
691
economic Darwinism, 690
role for regulation,
690–691
WorldCom (example), 606
Euronext, 581
Europe
antitrust case, 247
Lincoln Electric in, 503–504
relaxing labor laws, 657
722 Index
European banks
corporate culture, 369
European Commission, 246, 247
European Court of Justice, 246
European investment bankers
supply and demand for, 440
European labor laws, 657
European retailing, restricting
entry into, 676
European Space Agency, 690
EVA. See Economic Value Added
Evanitsky, Jennifer, 262
Everyday low prices, 281
Excess capacity, 202, 203
Exchange
in market economy, 68–75
and production, 90
Excite@Home, 14
Exclusive territories, free-rider
problems and, 638
Executives
stock options to motivate, 488
Executive turnover, 5
Exit, 204
Expected cash flows, 115
Expected compensation, 533
Expected value, 39
Expedia.com, 69
Expense centers, 542–543
summary of, 547 Experience goods, 204
Expert systems, at Xerox, 9
Explicit costs, 18
Extensive coordination, 624
Extensive form, 310–311
External benchmarking, 513
Externalities, 95–98, 624,
661–662
and Coase theorem, 95–98
External monitors, 598–601
ExxonMobil, 1, 66, 281
Fable of the Bees, 95–98 Fabrazme, 695
Fabrikant, G., 338
Facebook, 389
Factor-balance equation,
191–192
Factor demand curves, 180–183
Factors of production, superior,
273–277
producer surplus captured by,
273–276
second-price auctions, 276
team production, 276–277
team production capabilities,
276–277
Fair Labor Standards Act, 93
Falconi, M., 391
Fallat, A., 503
Fama, Eugene, 7, 38n, 397n,
404, 605n
Farrell, G., 330n
Farzad, R., 330
Fast, N., 502n
Fastow, Andrew, 1–2, 2n, 8, 609
Federal Communications
Commission, 193, 305
Federal Express, 271, 462,
697, 709
Federal Minimum wage, 95
Federal Reserve Bank of New
York, 685
Federal Trade Commission,
622, 664
Feedback from performance
evaluation, 504
Feintzeig, R., 368, 519
Feltham, G., 514n
Fernyhough, David, 660
Ferraro, P., 44
Feuerstein, Donald, 684
Fialka, J., 662
Fiat, 377
Fiduciary duty of managers, 113
Financial disclosure regulation,
657
Financial fraud, at Cendant
Corporation, 562
Financial Times, 698 Financing decision, firm’s, 65
Financing decisions, 113
Finder, A., 124
Fingerhut Business Services, 289
Fink, R., 550
Finkelstein, Paul, 176
Finnegan, R., 443
FinWare Inc., 411–433
Fiorina, Carly, 421, 594
Firms
Adam Smith on, 584
agency relationship, 340–341
architecture within, 358–360
controls, 359
decision rights, 358
trade-offs, 359–360
assignment of decision
rights, 4
“bond” product quality, 702
central planning within,
101–102
communication within, 382
contracting costs, 101–106,
103–106
contracts to control incentive
problems
costless contracting,
335–338
costly contracting, 338–339
postcontractual information
problems, 340–343
precontractual information
problems, 343–347
cooperation to increase value,
265–266
core activities and stock
value, 105
decentralization, 389–391
decentralized, 554
decentralized M form, 431
decision making within, 330,
376
degree of integration, 618
demand curves, 121n, 135–136
efficient, 106
external business
environment, 360
financing decision, 65
first-mover advantages, 141
flattened, 431
focal point for a set of
contracts, 331–332, 333
hiring decisions, 442
identifiable rivals, 259
implications of income
elasticities, 134
implicit contracts, 347
incentive conflicts within,
332–334
incentive problems between
homeowners and real
estate agents, 344
incentive problems
worldwide, 336
incentives to economize
contracting costs,
349–350
inter-temporal investment
decision, 64–65
managerial understanding of,
67
versus markets, 107 market value changes
1970–2013, 281
monetary size of, 66–67
owner-manager conflicts,
329–330
ownership versus franchising, 639
reducing contracting costs,
102–103
reputational concerns,
347–349
reputation for ethical
behavior, 686
resources and capabilities,
286
rising health care costs, 346
shutdown condition, 196
survival criterion, 7
vertical chain of production,
617–619
vertically integrated, 618
violating economics of trade,
72
Firm-specific assets, 622–623
dedicated assets, 623
human-asset specificity, 623
physical-asset specificity, 622
site specificity, 622
Firm-specific human capital,
443, 448
Firm supply, 195–197
First-degree price
discrimination, 236
First-mover advantages, 312
with new products, 141
Fischel, D., 589n
Fisher, 630
Fisher, B., 147
Fisher, George, 370
Fisher, Irving, 64
Fisher Separation Theorem,
64–65
financing decision, 65
Fitch, 600
Fitzgerald, R., 668
Fixed costs, 172, 173–174
magnitude of, 558n
Fixed proportions of inputs, 162
Flanigan, R., 485
Flatow, I., 245
Flattened firms, 431
Fleet Bank, 17
Flexible manufacturing, 278
Flexible production, 265, 268
Flynn, L., 69
Focal point, 303
Focal point for a set of
contracts, 331–332, 333
Foley, S., 257n
Folk Theorem, 315
Fong, K., 176
Food and Drug Administration
(FDA), 662
Food fraud, 697
Forced distributions, 518–519
Ford, Henry, 139
Ford, M., 711
Ford Motor Company, 139, 283,
367, 400, 616, 644, 694
in consumer credit business,
283–284
Forero, J., 70
Forest Laboratories, 550
Forgone complementarities
specialized task assignment,
412
Index 723
Fortune, 14, 410 Fortune 1000 firms, 592 Fortune Most Admired
Companies, 1
Forward integration, 618
Fowler, G., 390
Foxconn, 615–616
FOX network, 147
France, M., 655n
Franchise agreements, 618
Franchising versus company ownership, 639
Francis, T., 443
Frank, R., 43n
Fraud. See also Corporate scandals
at Cendant Corporation, 562
evidence on penalty from, 700
food, 697
in securities trading, 11–12
Fraudulent borrowers, 6
Free markets, 66. See also Market economy
Free-rider problems, 334, 395
company ownership versus franchising, 639
contracting with distributors,
636–638
advertising provisions,
637–638
exclusive territories, 638
control of, 524
costs of controlling of, 524
experimental evidence, 335
public goods, 663
Free samples, 245
French civil law countries, 590n
French labor laws, 526–527
Frequency of evaluation, 517
Frequent-flier mileage
programs, 19
Freudenheim, M., 296n
Friebel, G., 383n, 386
Fried, Jesse, 589n, 597n, 597
Friedlander, A., 159n
Friedman, Milton, 694
Fringe benefits, 455
to attract employees, 461–462
cafeteria-style plans, 462
compensation plans, 463
employee preferences,
455–457
employer considerations, 457
at Lincoln Electric, 460
mix of, 462–463
and overtime, 459, 460
salary–fringe benefit choice,
457–463
temporary and part-time
workers, 462
Fritsch, M., 604n
Fritsch, P., 20n, 674
Frivolous lawsuits, 661
Fujisawa, Takeo, 376
Fukui, Takeo, 377
Full-cost transfer prices, 559
Functional literacy, 443
Functional managers, battle of,
436–437
Functional myopia
specialized task assignment,
413
Functional subunits
benefits of, 420
building, 417–418
problems with, 420
work with, 422–423
Future costs, 245
Future demand, 244–245
Future income, 61–63
Future value, 63, 114
Gains from diversification, 285–286
Gains from trade
and absolute advantage,
72–73
comparative advantage,
71–74
measuring, 90–91
and monopolistic
competition, 208n
in personalized pricing, 236
from preferences, 69–70
in pricing policy,
224–225
versus strategic business planning, 72
unexploited by monopoly,
205–206
and U.S.–Venezuela
animosity, 70
and value creation, 75
Game theory, 208n, 296–328
Boeing vs. Airbus, 296–315 in cooperative equilibrium,
315
cooperative games, 298n
decision nodes, 311
dominant strategy, 214
incentive game, 316
key management insights
from, 319
managerial tool, 297
Nobel Prize winners, 298
noncooperative games, 298n
pure vs. mixed strategy, 306–308
purpose of, 297–298
repeated strategic
interactions, 314–315
secure strategy, 309
sequential interactions,
310–314
simultaneous move,
nonrepeated interaction,
299–309
analyzing payoffs, 299
competition vs. coordination, 303–305
coordination/cooperation
game, 306
dominant strategy, 300–301
managerial implications,
308–309
mixed strategies, 306–308
Nash equilibrium, 301–303
prisoners’ dilemma, 300
strategic interaction and
organizational
architecture, 316–318
subgame perfection, 313n
teammates’ dilemma, 323–328
tit-for-tat strategy, 325–327
Gaming, 510–511
student test scores, 491
Gaming the system, 19
Gap, Inc., 138, 281
Garcia, Leopoldo, 563
Gardella, A., 179
Gartner Inc., 231
Garvey, G., 453n
Gasoline
elasticity of demand for, 138
price for, 92–93
Gasser, Kenneth R., 289
Gates, Bill, 656
Gates, William, 100
Gaver, J., 597n
Gaver, K., 597n
Gavin, D., 381
G.D. Searle & Company, 317
General Electric, 281, 338, 377,
423, 453, 519, 573, 580,
596, 616, 630, 644
General Growth Properties, 492
General human capital, 443–444
General knowledge, 98–100
Generally Accepted Accounting
Principles (GAAP), 564,
579, 657
General Mills, 199
General Motors, 70, 157, 281,
283, 363, 381, 423, 544,
630, 643, 675, 677
in consumer credit business,
283–284
decentralization and costs of,
383
recall of, 687
vs. Chrysler, 8 Genzyme, 695
Georges, C., 669, 670
Gerhart, B., 454n
German Retailers’ Association,
676
Germany
corporate governance,
601–604
steel production, 181
Gibbons, R., 380n, 382, 386,
404, 416, 434, 512
Gibbs, M., 453n
Gibson, R., 283
Giffin Goods, 123n
Gilbert, N., 705n
Gillan, S., 612
Gillette, King, 263
Gillette Company, 263
Gilson, S., 593n
GitHub, 389
Glater, J. D., 124
GlaxoSmithKline (GSK), 550
Glickauf, Joseph, 572
Global Crossing, 571, 579
Global economy, demand for
steel, 156–157
Global entry program, 262
Globalization
by Lincoln Electric, 503
reducing scale economies,
202
Globalspec.com, 99
Global supply chain
and decentralization, 390
Goal-based system, 516–517
GOCE satellite, 690
Goizueta, Roberto, 691
Goldman Sachs Group Inc.,
280, 441, 579, 643
Golf ball manufacturers, 207
Golf magazine, 410 Good-citizen model, 34–35
limitations of, 36
Goodman, M., 443
Goodnight, Jim, 139
Goodnough, A., 540
Goods, 20
complements, 131–132
experience goods, 204
inferior, 56, 133–134
normal, 56, 133–134
perfect complements, 58
perfect substitutes, 58
substitutes, 131–132
Goodyear Tire, 284
Google, Inc., 99, 281, 377, 389,
583, 616, 646
decentralization at, 381
724 Index
Gore, Robert C., 469
Gould, J., 566
Government farm supports, 668
Government regulation
affecting business, 657
in business environment,
286–287
economic motives, 658–668
economic theory of, 668–675
demand for regulation, 669
incentives to free-ride and
form coalitions, 670–671
market for regulation,
671–674
supply of regulation,
669–670
European labor laws, 657
forms, 657
importance for managers,
656–657
limiting entry, 656
managerial implications, 675
on business participation in
political process,
679–681
forming coalitions,
678–679
restricting entry and
limiting substitutes,
675–678
Government regulation, of labor
markets, 525–527
Government restrictions
on entry, 203
on exit, 204
Grant, P., 193n
Graphical tools
for economic analysis, 20–27
income effect, 55
indifference curves, 40, 58
inter-temporal consumption
choice, 62
labor supply and income
effects, 57
producer surplus, 273–276
substitution effect, 55
Gravity (movie), 690 Graybow, M., 606
Gray market, 235, 701
Great Britain
food fraud in, 697
Greater New York Hospital
Association, 671
Great Lakes Aviation Ltd., 86
Greek law, 697
Green Food Company, 591
Greenspan, Alan, 608–609
Greer, J., 501
Grief, A., 659n
Grieve, H., 701n
Grisham, John, 261
Grizzly bears, 371
Grocery products
demand elasticities for, 125
Gross domestic products (GDP),
66–67
Grossman, S., 587n, 627n, 632n
Group incentive pay, 483–485
Group performance, 483
Group pricing, 237–238
Grover, R., 330n
Grow, B., 199
Growth stage, 140–141
Grubman, Jack, 579
Guay, W., 593n
Gudmundsen, J., 147
Guiso, L., 369
Gulf Oil, 281
Gulf War, 470
Gunther, M., 137
Gurley, J., 69
Gutfreund, John, 684
Guth, R., 243
Guyot, E., 10
Haas, Robert, 523 Hakonsson, D., 426n
Haldane, J., 689n
Hall, K., 277
Hall, R., 447n
Halliburton Company, 334
Hamel, G., 633
Hamilton, R., 595, 595n
Hamm, S., 643
Handley, H. Richard, 707
Hanlon, M., 333, 459n,
626n
Hansen, Patricia, 19
Hansen, Susan, 124
Happiness, 689
Happy-is-productive model,
33–34
criticism of, 36
versus economic incentives, 33
limitations of, 36
Hardin, G., 690
Hardware, software, and
wetware, 266
Harris, M., 492, 587n
Harris, N., 8n
Harry Potter books, 237 Harsanyi, John, 298
Hart, O., 331n, 351, 587n, 605n,
627n, 632n, 646
Hatvany, N., 526n
Hausman, J., 125
Hayek, Friedrich, 5n, 100n, 107
on market system, 100
on price system, 101
Hays, L., 469
Hazlett, T., 679
Health care system, 503
Health Fitness Corp., 368
Health insurance
costs, employee conflicts
over, 346
and ObamaCare, 33
Health maintenance
organizations, 503
Hebei Province, China, 181
Helyar, J., 329
Hendricks, W., 453n
Henkoff, A., 217
Hennessey, R., 457
Henry, J., 339n
Hermalin, B., 594n, 597n
Herman, E., 121n
Hermes Pension Management
Limited, 603
Herper, M., 492
Hershey Foods, 297
Hertz, 418
Hertz Equipment Rental
Division, 418
Herzberg, F., 33, 33n
Hewitt associates, 522
Hewlett, Walter, 594
Hewlett-Packard, 203, 289, 421,
462, 492, 594, 643
Hickman, K., 594n
High-definition television, 305
Hill & Associates Ltd., 660
Himelstein, L., 655n
Hindman, N., 492
Hindustan Lever, Ltd, 306
Hirai, Kazuo, 348
Hiring decisions, 442
Hirschey, M., 229n
Hirshleifer, J., 566, 703
Historical costs, 171, 226
HiTek Bikes, 555
Hitt, G., 669
Hogan, J., 443
Hog producers, and corn prices,
183
Holden, Betsy, 121
Holderness, C., 597n
Holdup problem, 623
Holland Sweetener, 317–318
Holmstrom, B., 5n, 383, 414n,
476n, 477n, 482n, 485n,
556n, 566, 583n, 646,
650n
Holt, C., 301
“Home Baker,” 118
Home Box Office, 193
Home building, 164
Home Depot, 117, 537
Homeowners and real estate
agents, incentive
problems between, 344
Honda, Soichiro, 376
Honda Motor Company,
376–377, 391
Honda System, 376
Honesty in local police force,
450
Horizon problem, 511
Horn, L. van, 370n
Horwich, J., 212
Howitt, K., 503
HSBC U.K., 369
Hughes, A., 17
Human-asset specificity, 623
Human behavior, 37–38
Human capital, 442–444
firm-specific, 443, 448
general vs. specific, 443–444
investment in, 444
pay level and value of,
442–444
skills lag in U.S., 443
Human-relations movement, 36
Human resources, 266
Hume, T., 123
Hurd, Mark, 421, 492
Hurricane Katrina, 117
Huselid, M., 453n
Hutton, A., 507n
Hyde, C., 551
Hymowitz, C., 384, 516
IBM, 203, 247–248, 281, 363, 421, 616, 619, 622, 628,
631, 635, 637, 643, 675
Ice cream wars, 306
Ickes, Harold, 671
Identification problem, 145
Idiosyncratic knowledge, 99
IKEA, 288
Illinois farmland, 279
Illium, Betsy, 135
Illustrated magazine, 410 ImClone, 688
Immigration acts, 657
Implicit contracts, 331–332,
347
enforceability of, 332
example, 332
Sony, 348
Implicit costs, 18
Import and export laws, 657
Import Quotas, 680
Imports, of copyrighted items
Supreme Court rules in favor
of selling, 235
Index 725
Inappropriate organizational
architecture
firing the manager, 370
market for corporate control,
370
product market competition,
371
Incentive coefficients, 499
Incentive compensation,
469–501
basic problem, 470–476
optimal risk sharing,
474–476
ownership, 473–474
and Chinese agriculture, 490
debate over CEO
compensation, 492
effective contracts, 476–489
group incentive pay,
483–485
incentive pay, 481, 486
information revelation, 487
informativeness principle,
482–483
multitasking, 485–486
principal-agent model,
476–481
selection effects, 488–489
effects of incentive pay,
489–493
Chinese agriculture, 490
multitasking theory, 498–501
Incentive conflicts
buyer-supplier conflicts, 334
contracts to control
costless contracting,
335–338
costly contracting,
338–339
postcontractual information
problems, 340–343
precontractual information
problems, 343–347
miscellaneous conflicts, 334
owner-manager conflicts,
332–333
worldwide, 336
Incentive contracts, 476–489
group incentive pay, 483–485
incentive pay, 481, 486
information revelation, 487
informativeness principle,
482–483
multitasking, 485–486
optimal contract, 479–480
principal-agent model,
476–481
relative performance contract,
482
selection effects, 488–489
Incentive game, 316
Incentive pay, 481, 486
Incentives
board member, 593–594
decentralization and, 382–384
individual and managerial,
4–5
in market economy, 100–101
ownership and control,
separation of, 582–583
postretirement, 605
shareholders, 590–291
specialized task assignment,
413–415
top management, 597–598
Incentive systems, poorly
designed, 6
Income
determinant of demand,
133–134
marginal utility of, 53
versus unlimited wants, 15 Income change
and budget constraint, 23, 24
effect on choices, 26–27
Income effect, 54–57, 123n
in labor supply, 57
Income elasticities, 134
estimates of, 134
implications for firms, 134
location decisions, 134
and log-linear demand
functions, 155
Incomplete contracts, 628
Increasing cost industry
versus constant-cost industry, 199–200
Increasing returns to scale,
158–159
Incremental costs, 16, 225, 226
Independent variables, 121
India
demand for steel, 156
Enron power plant, 2
ice cream wars, 306
Indian electronics product, 130
Indifference curves, 21–22
convex to the origin, 22,
57–58
for expected value, 40
and marginal analysis,
25–26
and marginal rate of
substitution, 51
and perfect complements, 58
and perfect substitutes, 58
slope of, 21–22, 50–51
for standard deviation, 40
Indirect costs of regulations, 662
Individual choice, 23–27
Individual demand, and price
discrimination, 236–238
Individual objectives, 20–21
Individual output, 522
and team output, 523
Individual performance, 483
Individuals
axioms of choice, 20n
bounded rationality concept,
16n
choices by, 16
creativity of, 18–20
inter-temporal investment
decision, 61–63
limited incomes, 16
trade-offs faced by, 18
unlimited wants, 15
utility functions, 20–21
Industry, 136n
Industry demand curve, 135–136
in competitive markets, 197
for new products, 140–141
Industry profits in competitive
and monopolized
markets, 671, 672f
Industry supply curve in
competitive markets, 197
Inelastic demand, 127
Inelastic price elasticity, 127
Inferior goods, 56
versus normal goods, 133–134
Inflation rate, versus price of steel, 156
Influence activities., 401
Influence costs, 401–403, 519
internal labor markets,
454–455
in universities, 454
Influencers, 368
“Informant!”, 217
Informational failures, 665–666
Informational specialization, 102
Information revelation, incentive
compensation and, 487
Information technology (IT), 118
Informativeness principle, 508
InfoSpace, 14
Infosys Technologies, Ltd., 643
Ingersoll, J., 534n
Ingrassia, P., 376n
Input prices
of aluminum, 157
changes in, 165–168
conflicts over, 334
and cost curves, 170
and isocost lines, 164–165
of metals, 171
and optimal input mix,
167–168
of steel, 156–157
Inputs
choice of, 162–168
diversity of, 696
factor-balance equation,
191–192
factor demand curves,
180–183
in fixed proportions, 162
measuring quality, 623
production functions,
157–162
retail supercenters, 168
returns to a factor, 159–162
and returns to scale, 158–159
substitution among,
162–164
“In Search of the Last Honest
Analyst” (Fortune), 14 Insider-trading violations, 688
Institutional investors,
590–591
Institutional stock ownership, 581
Insurance distribution systems,
501, 653
Insurance market
adverse selection in, 344–347
reducing adverse selection,
346
and self-selection, 346
Intangible assets, 266, 276
Integrity vs. money, 28–30 Intel Corporation, 271, 618
Intellectual property laws, 657
Interdependencies
within organization,
365–366
Interest rates, risk-free, 114
Interior solutions, 59
Internal accounting system,
560–564
Internal analysis, 287–288
Internal labor markets,
447–449
costs of, 448–449
in Japan, 448
long-term relationships,
447–448
employee motivation, 448
firm-specific human
capital, 448
learning employee
attributes, 448
pay in
careers and lifetime,
449–454
efficiency wages, 449–450
influence costs, 454–455
job seniority, 451–452
promotions, 452–454
726 Index
International corporate
governance, 601–604
International outsourcing. See also Outsourcing
politics of, 643
International trade
and strategic business
planning, 72
Internet, 90
book-selling industry, 308
online auctions, 138
reducing transaction costs,
262
Walmart.com, 289–290
Internet auctions, 350
Interstate Commerce
Commission (ICC), 664
Inter-temporal decisions, 61–65
budget line, 62–63
example of, 61–63
exercise for reader, 63
financing decision, 65
and Fisher Separation
Theorem, 64–65
terminology, 63
Inter-temporal investment
decision
by firms, 64–65
individual, 61–63
Interviews for demand
estimation, 141–142
Introduction stage, 140
Intrusion-detection software, 20
Intuit, 223–224, 225, 226, 228,
241, 242, 244
Investment banks
flawed stock analysis, 14–15
Investment centers, 544–548
residual income, 546
return on assets, 545–546
summary of, 547 Investment Dealer Digest,
349, 700
Investment decisions, 206
Investment incentives
and ownership rights,
628–629, 650–653
Investments
common stock, 115
constant growth model,
115–116
inter-temporal decisions,
61–65
risk-free, 114
risky, 41
Invisible hand, 82
iPads, 139, 615
iPhone, 315
iPhone pricing, 246
iPods, 618
Iraqi soldiers, 445
Iraq war, 334
Isaacson, W., 139
Isocost lines, 164–165
and cost minimization,
165–166
Isoquant, 162–164
slope of, 192
Italy, textile industry, 271
ITT, 285, 363
iTunes Music Stores,
248–249, 361
Jack, A., 266 Jack, Welch, 338
Jackson, David, 346
Jackson, Thomas P., 656
Jaguar, 428
Japan
corporate governance,
601–604
internal labor markets in, 448
lost and found articles, 34
Pfizer’s lost profits in, 133
Sony Corporation, 604
Jarrell, G., 285n, 286n, 400
JC Penney, 281
Jefferson, Thomas, 698n
Jenerette, Dick, 694
Jenner & Block law firm, 687
Jensen, Michael, 5n, 7, 12, 43,
98n, 107, 331n, 332n,
351, 352, 356n, 374,
397n, 404, 453n, 486n,
495, 539n, 582, 643n,
693n, 711
Jewitt, I., 416
Jimmy Beans Wool, 179
J&J credo, 708–709 Job requirement variations, 444
Job rotation, 507
Jobs
building into subunits,
416–417
environment, strategy, and
architecture,
423–424
functional and product or
geographic subunits,
trade-offs between,
420–423
grouping by function,
417–419
grouping by product or
geography, 419–420
matrix organizations,
424–426
mixed designs, 426
network organizations, 426
organizing within subunits,
426
compensating wage
differentials, 444–446
dimensions, 378–379
unpleasant, 445
Jobs, Steve, 139, 246, 249, 615
Job satisfaction, 34
good-citizen model, 34
happy-is-productive model,
33, 34
only-money-matters model,
33
Job seniority, 451–452
Jog PCS, 427
John, K., 621n
Johnson, B., 605n
Johnson, D., 338
Johnson, J., 118n
Johnson, M., 510
Johnson, Robert Wood, 708
Johnson, Ross, 338–339
Johnson & Johnson, 266, 281,
708–709
John Wiley & Sons, 235
Joint interests, 214–215
Joint outcome, 474n
Joint ownership conflicts, 334
Joint ventures, 618
R&D, 266
Jones, Barbara, 606
Jones, Bobby, 483
Jones, Terrell, 656
Joye, M., 595n
JP Morgan Chase, 281, 399, 579
Jupiter Communications, 289
Justice Department, 655
Kabak, Scott, 199 Kageyama, Y., 376n
Kahn, J., 181
Kamm, T., 657
Kandel, E., 485n, 659n
Kantowitz, B., 335
Kaplan, R., 507n
Kaplan, S., 473n, 583n, 593n
Karpoff, J., 700
Karr, A., 455n
Katz, D., 548
Katzenbach, J., 532n
Kaufmann’s, 463
Kawamoto, Nubuhiko, 377
Kaye, B., 704n
Kearns, David, 370
Keck, John, 246
Kentucky Fried Chicken (KFC),
8, 267, 696
Kerr, J., 305
Kerry, J., 643
Kerviel, Jérôme, 11–12
“Killer B” stocks, 588
Kim, H., 290n
Kim, S., 123
Kim, W., 630n
KinderCare Learning Centers,
285
Kindle, 616
King, N., Jr., 334
King, R., 523
Klamer, M., 624n
Klein, B., 622n, 638n, 646
Klein, R., 334
Klockner, 157
Kmart, 300, 390, 537
Knauss, Don, 419
Knight, Frank, 5n
Knowledge
changes in transfer costs, 9
converted into value, 266–267
creation, decision right
assignment and,
399–400
effective use of, 380–381
general vs. specific, 98–100 team decision making and
improved use of, 394
transfer costs, 98
Knowledge creation, 117–119
Kobayashi, Hiromi, 402
Koch Industries, 580
Koening, R., 469
Kohlberg Kravis Roberts &
Company, 329–330, 370
Kohl’s, 281
Kohn, Alfie, 489, 489n
Kollar-Kotelly, Colleen, 656
Kornblatt, L., 509
Kozlowski, Dennis, 609, 694
KPMG, 428
Kraft Foods, 121, 199
Kramarz, F., 527n
Kreinin, M., 673
Krenzke, T., 443
Kreps, D., 374
Kripalani, M., 643
Kroger, 173
Kroszner, R., 597n
Krueger, A., 94n
Kuhn, Dana, 695
Kulp, S., 514n
Kuntz, P., 669
Kupiec, E., 454n
Labate, J., 648n Labich, K., 138
Labor
relative cost at SeaTac
Airport, 167
Index 727
Labor demand, after terrorist
attack, 183
Labor disputes, in Hockey, 314
Labor laws, 657
in Europe, 657
Labor-management quarrels, 334
Labor market. See also Internal labor markets
basic competitive pay level
model, 441–442
government regulation of,
525–527
Labor supply
income effects, 57
Labor Union Laws, 680
Lafontaine, F., 632,
639, 646
Lambert, R., 514n
Lancaster, K., 139n, 202n
Landa, J., 700n
Landler, M., 181
Landon, B., 503
Land Rover, 428
Langley, M., 399
Langton, N., 454
Lanier, 619
La Porta, Rafael, 590n
Larcker, D., 593n
Large blockholders, 590
Lateral decision-right
assignment, 393
Latour, A., 465n
Launder, W., 410n
Lavin, D., 334n
Law. See Government regulation; Sarbanes-
Oxley Act
Law of demand, 123
on price elasticities, 124
Law of diminishing marginal
product, 160
Law of diminishing marginal
returns, 199
Law of diminishing returns,
160–161
Law of Increased
Dimensions, 158
Law of One Price, 645
Lawrence, J., 183
Lazear, E., 451n, 452n, 485n,
489n, 598n, 659n
LDDS (Long Distance Discount
Service), 578
Lead directors, 8
growth in, 8
Learning curve, 177–178
as barrier to entry, 204
versus economies of scale, 178
effects in pricing, 245
LearnVest, 31
Lease, R., 587n, 590n
Lease contracts, 618
Lee, C., 95
Leech, John, 428
Leeds, J., 248n
Legal standards, 696–697
Legal traditions, 590n
Legislation, 590n
Lehman Brothers, 643
Lehn, K., 581n
Leibtag, E., 125
Leisure vs. work decision, 57 Lemon law, 666
Lenovo, 616
Leone, A., 506n, 600n
Leonhardt, D., 389
Let’s Make a Deal, 311
Levi jeans, 523
Levi Strauss & Co., 396, 523
Levitt, Arthur, 575
Levitt, S., 344
Liar loans, 6
Liberia, ships registration
in, 675
Licensing
as barrier to entry, 203–204
Liebeck, Stella, 659
Lieberman, D., 330n
Lieberman, Marvin, 178
Life versus money, 31 Light, J., 522
LightCo., 629, 630
Limos, in Las Vegas, 668
Linck, J., 5n, 634
Lincoln Electric Company,
489, 507, 518, 522, 540,
618, 697
benchmarking, 372
fringe benefits at, 460
global expansion, 503
history, 502
performance evaluation at,
503–504
strategy, 502
Linear approximation method,
228, 230
Linear compensation contracts,
477n
Linear demand curves, 129–131
marginal revenue, 129
marginal revenue for,
154–155
profit maximization, 129–131
total revenue, 129
Linear supply and demand,
80–82
Litan, R., 510
Livermore, Ann, 421
Loans, 6
Local knowledge. See also Knowledge
effective use of, 380–381
Local police force, honesty
in, 450
Location decision and income
elasticities, 134
Lock-in effect, 245
Log-linear demand functions,
155
Lomax, A., 492
London Stock Exchange, 581
London Whale, 399
Long, J., 242n
Long Distance Discount Service
(LDDS), 578
Long-run average cost,
196–197, 245, 273,
274, 620
Long-run average cost curves,
174
Long-run cost curves, 174–175
as planning curves, 171
Long-run costs, 184
Long-run effects, supply and
demand analysis, 85–86
Long-run marginal cost,
196–197
Long-run marginal cost curves,
175
Long-run supply decisions,
196–197
Long-term contracts, 618
advantage of, 635
franchise agreements, 618
joint ventures, 618
lease contracts, 618
standard supply and
distribution
contracts, 618
strategic alliances, 618
versus vertical integration, 627–635
asset ownership, 632–633
continuum of choice,
634–635
incomplete contracting, 628
other reasons, 633–634
ownership and investment
incentives, 628–629
specific assets, 629–632
vs. short-term contracts, 635 Long-term employment
relationships, 447–448
employee motivation, 448
firm-specific human
capital, 448
learning employee
attributes, 448
Loomis, C., 257n
Lopez, J., 531n
Lopez-de-Silanes, F., 581n, 590n
Lorenz, A., 637
Lott, J., 700
Lott, Trent, 669
Low-carb food, 199
Lower cross-training expenses.
specialized task assignment,
412
Lublin, J., 443
Lucent Technologies, 362
Lutz, B., 364
Luxuries versus necessities, 128 Lysine industry price fixing, 217
MacDonald, John, 86 Machalaba, D., 362
Macintosh, 615
Macy’s, 281
“Made in the USA,” 622
Maher, K., 459
Majority voting, 407–409
Make-versus-buy policies, 632 Malaysia, 176
Malson, Kelly, 31
Malthus, T., 118–119, 118n
Management implications
decentralization
across firms, 389–391
recent trends,
391–393
of demand estimation, 146
of efficient markets, 117
GM’s recall, 687
Nash equilibrium in game
theory, 303
repeated interaction games,
308–309
of sequential interactions, 313
team decision making,
395–396
effeciveness, 396
optimal team size, 396
of teammates’ dilemma,
327–328
Managements Smarts, Inc., 118
Management time, conservation
of, 381
Managerial decisions, 106–108
AutoCorp, 644
Bagby Copy Company,
431–432
ban on advertising, 304
BioChem pricing policy, 635
at Bobby’s Burgers, 483
Celtex, 563
choosing input mix, 168
collective decision
making, 409
728 Index
comparative advantage in
workplace, 75
compensation plans, 463
consumer choice, 27, 60
Copper Box Company, 553
cruise line compensation
structuring, 456
debate over CEO
compensation, 492
13D filings, 591
eBay, 350
economies of scale, 176
effect of Microsoft Case on
other computer
firms, 679
entry decision, 212
ethanol and pork prices, 81
fringe benefits at Lincoln
Electric Company, 460
HiTek Bikes, 555
Holland Sweetener vs. Monsanto, 317–318
insurance industry
distribution systems,
501, 653
at Interwest Healthcare Corp.,
37
iTunes pricing, 248–249
Jog PCS, 427
leaving New York for Illinois,
279
Let’s Make a Deal, 311
with marginal analysis, 19
Medford University, 402
new restaurant concept, 272
oil industry distribution
systems, 642
opening a new restaurant,
339–340
personal video recorders,
146–147
on price system, 101
on pricing and investment, 206
pricing policy, 224
profit potential, 232
at Rich Manufacturing
Company, 185
shareholder value and market
efficiency, 117
at Société Générale, 11–12
Sotheby’s Holdings, 588
structuring salesforce
compensation, 536
team failure, 524
teams at Nucor versus Levi Strauss, 396
tipping in restaurants, 363
Tylenol Tragedy and J&J’s
Credo, 708–709
at United Airlines, 201
Walmart.com, 289–290
Wilmorite mall development,
693
World Motors (WM), 680
Managerial economics
economic analysis, 4–7
scope of, 3
Managerial implications
of economic analysis, 30–32
of economic Darwinism, 9
organizational architecture,
371–373
Managerial labor market, 605
Managerial misconception, 179
Managerial objectives
increasing profit, 104–106
shareholder value and market
efficiency, 113–119
Managerial power theory, 597
Managers
cost estimation by, 184–185
fiduciary duty, 113
financing decisions, 113
firing, 370
functional, battle of, 436–437
knowledge of product
demand, 121
and models of economic
behavior, 35–37
pricing decisions, 120–121
responses to problems, 15
risk-averse preferences, 41n
training and motivation,
381–382
understanding market
environment, 194
Mankiw, Gregory, 643
Manpower, 657
Mansfield, E., 127, 133, 134
Manulife, 619, 631, 635
Manzoni, Cynthia, 37
Marginal analysis, 16–18
of customer profitability, 17
for individual choice, 25–26
for managerial decisions, 19
of profit maximization,
179–180
Marginal benefits, 16–18,
179–180, 479
Marginal cost, 16–18, 179–180
independent of fixed costs,
174
long-run, 196–197
in monopoly, 205
price below, 245
short-run, 196
Marginal cost curve, 169, 170
and production function, 170
Marginal-cost transfer prices,
557–558
Marginal product, 159–162
ratio to price, 166
Marginal productivity, 504
estimation for performance
evaluation, 505
Marginal product-price ratio, 170
Marginal rate of substitution,
52, 53, 58
definition, 51
and substitution effect, 58
Marginal revenue, 129
and demand elasticities,
154–155
and linear demand curves,
129, 154–155
in monopoly, 205
Marginal revenue product, 182,
183
Marginal utility, 49–50
and equal marginal principle,
52, 59
of income, 53
Market area, 136n
Market-based transfer prices,
556–557
Market-basket data, 262
Market-clearing price, 76, 77
Market economy
versus central planning, 98–101
exchange in, 68–75
Hayek on, 100
linear supply and demand,
80–82
price as social coordinator, 82
price mechanism, 76–78
and property rights, 68–75
specific knowledge, 100
use of incentives, 100–101
Market environment, 194
Market failures, 658, 660
redressing, government role
in, 660–661
externalities, 661–662
informational failures,
665–666
monopoly, 663–665
public goods, 663
Market forces, 604–606
Market power
with barriers to entry,
201–204, 270
buyer and supplier power, 271
versus competitive industries, 270
degree of rivalry, 271
economic profit without, 280
with elastic demand, 227
in monopolistic competition,
206
and nonmarket transactions,
624–626
and pricing at Microsoft, 231
pricing decisions with,
224–225
and strategy, 271–272
target returns based on, 229
and threat of substitutes, 271
Market price, 197
Market research, 139
Market(s)
Adam Smith on, 584
architecture of, 357–358
in business environment, 286
for cable TV, 193–194
competitive, 76
for corporate control,
604–605
versus firms, 107 managerial labor market, 605
noncompetitive, 76
product market, 605–606
reducing contracting costs,
102–103
Simon on, 103
spontaneous creation of, 358
Market segmentation, 246
Market share, in antitrust cases,
136n
Market structure, 195
and barriers to entry, 201–204
cartels, 215–217
competitive markets, 195–201
in monopolistic competition,
206–207
monopoly, 204–206
oligopoly, 208–217
Market transactions, 619
Market value
changes 1970–2013, 281
collapse at Enron, 2
Market wage rate, 441
Markowitz, H., 475n
Markup pricing, 230
Markups, optimal, 227
Marlin Water Trust, 2
Marmots, 371
Marriott Hotels, 137
Marron, K., 137
Mars, 580
Mars Corporation, 297
Martha Stewart Living, 688
Martinez, A., 167
Marvel, H., 636n
Maslow, Abraham H., 33, 33n
Masten, Scott, 632
Matrix organizations, 424–426
Matsushita, 117–118,
203, 277
Mattel, 400
Index 729
Mattioli, D., 392
Maturity stage, 140
Mausner, B., 33n
Maximin strategy, 309n
Maydew, E., 459n, 550n, 626n
Mayers, D., 456n, 630n
Maylie, D., 89
McAfee, P., 170n
McCartney, S., 19, 686
McConnell, J., 587n
McCormally, Timothy, 665
McCormick, R., 670n,
676n, 678n
McDonald’s Corporation, 119,
138, 624, 659, 696
diversification mistakes, 283
value creation, 266–267
McGee, J., 371
MCI, 578
McIntyre, D., 629
McKesson, 492
McKinnon, S., 562n
McKinsey, James O., 543
McKinsey & Co., 543
McMillan, J., 170n, 199, 320,
352, 490, 495
MC=MR
in monopoly, 205
for profit maximization, 226
McNeil Consumer Products,
708
McWilliams, G., 421
Meadows, D., 119n
Means, G., 335n, 582
Measelle, Richard, 573
Measurement costs,
507–509
Measuring quality, 623
Meckling, W., 5n, 18n, 32n, 43,
98n, 107, 331n, 351,
356n, 374, 404, 539n,
693n, 711
Medford University, 402
Mediacom, 194
Medicare, perverse incentives
from, 32
Medoff, J., 518n
Meet-the-competition clauses,
216–217
Mehta, S., 212
Meineke Discount Muffler
Shops, 637
Meller, P., 246
Menu pricing, 239
Mercer Management, 524
Merchant reputation
Adam Smith on, 698
Merck & Co., 518
Merit rating, 503
Meriwether, John, 684
Merrill Lynch, 31, 34, 35, 38,
280, 366, 371, 600,
661, 702
flawed stock analysis, 14–15
motivating honesty at, 28–30
Metals prices, 156–157, 171
Meyer, C., 531n
Meyers, Donna, 71, 72n, 74n
Mian, S., 284n
Michaels, D., 296n
Michaud, M., 527n
Microsoft Corporation, 100,
116, 241, 243–244, 271,
281, 363, 368, 462, 519,
580, 655–656, 664, 675,
676, 679
antitrust suit, 669, 670
market power and pricing, 231
Middlebury College, 694
Mighty Morphin Power
Rangers, 390
Mikkelson, W., 587n
Miles-per-Gallon Standards, 680
Milgate, M., 107
Milgrom, P., 356n, 374, 401n,
414n, 477n, 480n, 485n,
495, 508n, 630n
Milkovich, G., 454n, 525n
Miller, G., 323n, 352, 404
Miller, Merton, 38n
Mini, 428
Minimum efficient scale,
175–177
and barriers to entry, 202
Minimum wage
effect on employment, 167
Minimum wage law, 93, 94
Misra, S., 636
Mitchell, M. L., 587n
Mitchell, R., 523
Mitsubishi, 376, 450
Mixed designs, 426
Mixed strategies, 306–308
Mixed-strategy equilibrium,
316, 317
The Modern Corporation and Private Property, 582
Modern finance theory, 65
Moeller, M., 655n
Mohadjer, L, 443
Money
life versus, 31 time versus, 31
Money magazine, 410 Monitoring costs, 340
Monopolistic competition
compared to monopoly,
206–208
cost curves, 207
gains from trade, 208n
golf ball manufacturers, 207
Monopolists, optimal pricing
policy, 226–227
Monopoly, 204–206, 663–665
and antitrust laws, 206n
MC=MR, 205
output decisions, 205
pricing policy, 205
profit maximization, 205
unexploited gains from trade,
205–206
Monopoly rents, 269n
Monsanto Company, 317–318,
400
Monsanto Fund, 694
Montgomery, C., 272n, 277, 293
Moody’s, 600, 700
Moore, J., 619
Moore, Pattye, 268
Moral-hazard, 487n
Morath, E., 95
Morck, R., 591
Morgan Stanley, 280, 297
Mortgage brokers, 6
Mortgages, subprime, 6
Most-favored-nation clauses, 216
Motivation
local managers, 381–382
Motorola, Inc., 10, 377, 609,
616, 619
Motor Trend magazine, 377 Movement along a demand
curve, 123
Movement of entire demand
curve, 123
Mozer, Paul W., 684–685
MRS. See Marginal rate of substitution
Mueller, Helmut, 313
Mulherin, J. H., 587n
Mulligan, Casey, 33
Multicollinearity, 144
Multidivisional form (M form)
of organization, 419
Multinational companies
and centralization, 384
and decentralization, 384
Multinational counterfeiting,
660
Multiperiod pricing
considerations
future costs, 245
future demand, 244–245
storable products, 246
Multitask agency problems
theoretical research in, 416
Multitasking, 485–486
and unbalanced effort,
514–515
Multitasking theory, 498–501
model, 498–500
telecommuting, 500–501
Murad, Walid, 563
Murphy, K. J., 5n, 453n, 484n,
486n, 492, 495, 512,
518n, 638
Nader, Ralph, 692 Nagel, T, 251
Nalebuff, B., 293, 307n, 318,
320
NASA, 690
NASDAQ, 586
Nash, John, 209, 298
Nash, L., 711
Nash equilibrium
and circle technique, 302
focal point, 303
in game theory, 301–303
dominant strategy, 301
identifying, 302–303
management implications,
303
likelihood of, 301
and oligopoly, 208–210
and price competition,
212–213
in prisoners’ dilemma,
214–215
second potential, 313n
Nasser, Jacques, 694
Nasser, Sylvia, 298
National Hockey League (NHL)
labor dispute, 314
National Institutes of Health,
697
National Rifle Association, 670
Natural selection, 371
NBC network, 147
NEC, 277
Necessities
versus luxuries, 128 Negligence, 584
Negotiated transfer prices,
559–560
Neilson, G., 396, 419
Nell Minow, 694
Nelson, E., 262n
Nestin, S., 242n
Netflix’s corporate culture, 367
Netscape, 655, 669, 676
Netter, J., 286n
Network effects
and demand, 136–138
on eBay, 138
and product design, 137–138
and product pricing, 137–138
Network organizations, 426
Neuborne, E., 524
730 Index
Nevada State Transportation
Services Authority
(TSA), 668
Nevius, A., 550
Newman, J., 454n, 525n
Newman, P., 107
New product introduction, 140
New products/services, to
increase value, 265
Newton, L., 711
New York Attorney General, 14
New York City Council, 671
New York Stock Exchange
(NYSE), 581, 586
New York Times, 11 NeXT Computer, 615
Nguyen, Lan, 436–437
Nicas, J., 86
Nielsen, J., 426n
Nintendo, 616
Nissan, 276
Nixon, Richard M., 297
Nixon-Peabody, 333
Nobel, Alfred, 298
Nobel Prize in Economic
Sciences, 298
Noguchi, Y., 308
Nomura Securities Company,
280
Nonaka, I., 117n
Noncompetitive markets, 76
Noncooperative actions, 209
Noncooperative games, 298n
Noncooperative pricing,
263–264
Nonmarket transactions, 619,
621–627. See also Vertical integration
and contracting costs,
621–624
controlling externalities,
624
extensive coordination, 624
firm-specific assets,
622–623
measuring quality, 623
and market power,
624–626
and taxes and regulation,
626–627
technological factors, 627
Nonrepeated interaction,
299–309
Nordstrom, 281
Noreen, E., 704n, 711
Normal form, 299
Normal goods, 56
versus inferior goods, 133–134
Normative analysis, 687
Normative ethics, 687
North Carolina Banks, 363
North Carolina Wesleyan
College, 124
Northwest Airlines, 212
Novartis, 391, 492
Nucor, 396
Nussel, P., 315
NutraSweet, 317, 318
Oak Hill Country Club, 77 Oakley, C., 31
“ObamaCare,” 33
Objective performance measure,
505
O’Brien, Ken, 511
Occupational Safety and Health
Administration (OSHA),
662n, 680
Occupational safety regulations,
657
Ocean Spray, 333
O’Connell, V., 121n
Ofek, E., 621n
Offshoring, 643. See also Outsourcing
O’Hagan, Colleen, 380
Oi, W., 233n
Oil extraction and production,
274–276
Oil industry distribution
systems, 642
Oil prices
decline after 9/11, 2
effect of terrorist attack, 137
rise in, 6–7
O’Keefe, B., 137
Okumura, Ariyosh, 603
Oligopoly
cartels, 215–217
Cournot model, 210–211
decision making in, 208
definition and examples, 208
duopoly, 209–210
empirical evidence, 213–214
equilibrium in, 210
Nash equilibrium, 208–210
output competition, 210–212
price competition, 212–213
and prisoners’ dilemma,
214–216
strategic thinking, 208
Olympus Corporation, 336
Omitted variables problem,
143–144
Onishi, N., 34
Online auctions, 138
Online pricing errors, 123
Online résumés, 90
Online shopping, 123
Only-money-matters model, 33
Operating curves, 171
Oppel, R., 540
Oppenheimer, Robert, 589
Opportunistic behavior, 509
gaming, 510–511
horizon problem, 511
Opportunities and constraints,
22–23, 24
Opportunity cost, 18, 554–555
and budget constraint, 22–23
and cost curves, 171
of leisure vs. work, 57 in petroleum business,
274–275
and profit maximization, 226
Opportunity costs, imposed by
regulation., 665
Optimal choice, 24–26
effect of price changes, 26–27
Optimal consumption bundle,
52–53
Optimal consumption choice, 63
Optimal contract, 479–480
Optimal input mix, and input
price changes, 167–168
Optimal risk sharing, 474–476
Optimal team size, 396
Optimal weights in relative
performance contract,
533–535
Optional bundling, 244
Orange County, 661
Ordinal ranking, 49
Oregon Public Utilities
Commission, 261
Organizational architecture,
3–4, 259, 355–374,
423–424
Arthur Andersen LLP (case
study), 571–576
business ethics and, 688
at Century 21, 359
in China, 10
corporate culture, 366
and communication, 367
complements, 368–370
and employee expectations,
368
corporate governance,
584–585
board of directors, 591–594
decision rights, 585–586
external monitors, 598–601
shareholders, 586–591
top management, 594–598
defined by contracts, 335
determinants, 360–366
changing architecture, 364
interdependencies and
complementarities
within organization,
365–366
in economic analysis, 5
and economic Darwinism, 9
fundamental problem, 357
within firms, 358–360
markets, 357–358
inappropriate
firing the manager, 370
market for corporate
control, 370
product market
competition, 371
managerial implications,
371–373
benchmarking, 372–373
evaluating management
advice, 372
and outsourcing, 616
primary goal, 357
relative versus absolute, 584 and strategic interaction,
316–318
strategy, 288
and team capabilities, 277
transfer across global
economy, 10
Organizational change, 9
Organizational design
and managerial incentives,
4–5
Organizational knowledge,
converted into value,
266–267
Organization(s)
corporate form of, 580
efficient, 106
M form of, 419
nature of, 10
Simon on, 103
U form of, 417
The Origin of Species (Darwin), 7
Oster, S. M., 201n
Out-of-pocket costs, 341, 342
Output
of competitive firms, 196
costs of production, 168–179
cumulative production,
177–178
of monopoly, 205
production functions,
157–162
profit-maximizing level,
179–180
returns to a factor, 159–162
and returns to scale, 158–159
Output competition, 210–212
Index 731
Outside directors, 592
Outsourcing, 615–653. See also Long-term contracts;
Vertical integration
choice along continuum, 619
described, 618
failure of, 637
international, politics of, 643
and organizational
architecture, 616
questions related to, 616–617
trends in, 642–645
vertical, by Taiwan
Semiconductor, 619
Overinvestment conflict, 333
Overtime
fringe benefits and, 459, 460
Ovide, S., 519
Owner-manager conflicts
Adelphia Communications,
330
choice-of-effort, 332
differential horizons, 333
differential risk exposure,
332–333
overinvestment, 333
perquisite taking, 332
RJR-Nabisco, 329–330
and spectrum of
organizations, 333
Ownership
and control, separation of
incentive issues, 582–583
publicly traded
corporations, 583–584
survival of corporations,
583
incentives from, 473–474
risk aversion, 474
team production, 474
wealth constraints, 474
rights, and investment
incentives, 628–629,
650–653
Ownership claims, 333
Ownership structure,
701–702
Oyer, P., 484n
Page, Larry, 389 Pajor, Edmond, 696
Paletta, D., 95
Pappas, J., 229
Pare, T., 699
Pareto, Vilfredo, 67n
Pareto efficiency, 67–68
for perquisite-taking, 337
Parker Hannifin Corporation,
230
Parkleigh Pharmacy, 463
Parks, Alvin, 231
Parmalat, 579, 584, 602
Parsons, H., 512n
Partnerships with Enron
Corporation, 2
Part-time workers, 462
Passing the baton pattern, 596
Past performance, and ratchet
effect, 506–507
Pasztor, A., 362
Patent protection, 659
Patents
as barrier to entry,
203–204
Priceline.com, 69
Patient Services, 695
Patterson, Deborah, 694
Pay
in internal labor markets
careers and lifetime,
449–454
efficiency wages,
449–450
influence costs, 454–455
job seniority, 451–452
promotions, 452–454
for performance, in health
care system, 503
in universities, 454
Pay level
basic competitive model,
441–442
at Cisco, 443
compensating differentials,
444–446
human capital, 442–444
market wage rates, 446
Payoffs
expected value of uncertain,
39
in game theory, 299
in incentive game, 316
and risk premium, 40
secure strategy, 309
in sequential interactions,
310–311
in teammates’ dilemma,
323–327
variability of, 39
PayPal, 350
Peck, S., 453n
Peer evaluations, 517
Peer pressure within teams, 523
Pekkarineny, T., 481
Pentagon attack, 137
Pentecoste, Pino, 436–437
People magazine, 410 Pepsi, 132, 317, 318
PepsiCo, 7–8, 179, 272, 297
Pereira, J., 390
Perfect capital markets, 64, 65
Perfect competition, 195–196
Perfect complements, 58
Perfectly competitive market,
121n
Perfect substitutes, 58
inputs, 162–163
Performance evaluation, 365,
502–536, 560–564
combining objective and
subjective, 520–521
government regulation,
525–527
at Lincoln Electric, 503–504
measurement costs, 507–509
merit rating, 503
opportunism, 509–511
optimal weights in relative
performance contract,
533–535
pieces produced, 503
principal-agent model,
504–505
reasons for, 504
relative, 511–513
setting benchmarks, 505–507
subjective, 513–520
team performance, 521–525
Performance evaluation
systems, 4, 10
Performance measures
and decision rights, 543
V.A. hospitals, 540
Perloff, J., 118n, 214n, 627n,
642n, 646
Perquisite-taking, 332, 334
contracts to control, 335–336
by Jack Welch, 338
and Pareto efficiency, 337
Perry, N., 454n
Personal computers
vertical chain of production
for, 617–618
Personalized pricing, 236
Personal video recorders,
146–147
Petco, 135
Pfanner, E., 247
Pfeffer, J., 454
Pfizer, 133, 266
PGA tournament, 77
Pharmacies, 173, 691
Philips Electronics, 630
Phillips, M., 462
Physical-asset specificity, 622
Piece-rate system
in performance evaluation,
503
Pigou, A. C., 236n
Pilots, supply of, 86
Pindyck, R., 219
Pioneering brand advantages,
204
Piore, M., 465
Pizza Hut, 8
Planned Parenthood, 698
Planning curves, 171
Plant closings, restrictions
on, 204
Plant location, 181
Plant size, 173–175
PlayStation 4, 616
Plywood production, 201
Point elasticities, 125n, 154
Polgreen, L., 96
Political coalitions, 679
Political support functions, 672
Politicians, supply of regulation
by, 669–670
Politics, of international
outsourcing, 643
Pollution
in China, 181
in Ruhr Valley, 181
Pomerantz, D., 443
Pork prices, 81, 183
Porta, R. La, 581n
Porter, M., 270n, 293
Posner, R., 642n
Possible equilibrium, 216n
Postcontractual asymmetric
information, 487n
Postcontractural information
problems
agency problems, 340–341
example of agency costs,
341–343
Postrel, V., 74
Postretirement incentives, of
CEOs, 605
Powell, B., 137
PPG Industries, 520
Prahalad, C., 633
Precommitment contracts, 203
Precontractual asymmetric
information, 487
Precontractual information
problems, 343–347
Preferences, 20–21
changes in, 27–28
codes of ethics, 705–706
and indifference curves, 21–22
inter-temporal consumption,
61–65
risk-averse, 41n
Prendergast, C., 490n, 491n,
511n, 517n, 521n
Prepay transactions
and commercial Banks, 599
732 Index
Present value, 63, 114
Presiding directors, 8
Press standard, 698
Price and entry restrictions,
657
Price changes
and budget constraint, 23, 24
causes of, 6–7
effect on quantity demanded,
124
income effect, 54–57
and optimal choice, 27–28
substitution effect, 54–57
a total revenue, 127
Price competition
Boeing vs. Airbus, 300–301 in oligopoly, 212
Price controls, 92–93
Price cutting threat, 202
Price discounts, 241
Price discrimination, 234
and antitrust law, 626
by cell phone companies, 241
and distribution of demand,
239–242
first-degree, 236
identifying submarkets, 235
and individual demand,
235–238
and price elasticities of
demand, 234–235
Robinson-Patman Act, 247
by Sears.com, 244
second-degree, 239
third-degree, 237
and vertical integration,
625–626
Price discrimination strategy, 578
Price elasticities
brand loyalty and, 128
calculating, 125–126
compared to cross elasticities,
132–133
determinants, 127–128
elastic, 127
inelastic, 127
and log-linear demand
functions, 155
and markup pricing, 230
measure of price sensitivity,
226
and point elasticities, 125n,
154
range of, 125, 126
of selected products, 127
unitary, 127
Price elasticity of demand,
125–126
Price experimentation, 142–143
Price fixing, 216, 588
in auto-parts industry, 315
Price floors, 93–94
Price leader, 216
Priceline.com, 69
Price mechanism/system, 60,
76–78
and demand curve, 77, 78
and equilibrium, 76
Hayek on, 101
at PGA tournament, 77
supply and demand, 76–78
and supply curve, 77
Price-quantity combination
and markup pricing, 230
and point elasticities, 154
and profit maximization, 224
Price(s)
below marginal cost, 245
of cable TV vs. satellite TV, 193
in competitive firms, 196
of complements, 263–265
in demand analysis, 122
effect of demand shift, 77
full-cost transfer, 559
government intervention,
91–95
industry cost and, 86–90
in law of demand, 123
marginal-cost transfer,
557–558
market-based transfer,
556–557
market-clearing, 76, 77
of metals, 156–157, 171
mistakes in online, 123
negotiated transfer, 559–560
of plywood, 201
profit-maximizing, 228–230
versus quantity adjustments, 82–85
relation to demand, 120–121
relative, 23
second highest valued use, 276
as social coordinator, 82
of steel vs. aluminum, 157 substitutes, 265
of sugar with tariffs, 273
and surplus or shortage, 77
Price sensitivity, 226–227
and cost-plus pricing,
228–229
and optimal markup, 227
Prices of related goods
complements vs. substitutes, 131–132
cross elasticities, 132–133
Price takers, 195
Price wars, 212
Pricing decision, 206
Pricing objective, 224
Pricing policy, 4
airlines, 128
Bertrand model, 212n
BioChem, 635
for books, 237
by cell phone companies, 241
complexities, 224
cost-plus pricing, 185,
228–229
everyday low prices, 281
with free samples, 245
with homogenous demand,
232–234
illegal tying arrangements,
248
implementation, 248
by Intuit, 224
legal issues, 247
lock-in effect, 245
with market power, 224, 225
market power at Microsoft,
231
and markup pricing, 230
in monopoly, 205
multiperiod considerations,
244–246
noncooperative, 263–264
in oligopoly, 208
at Parker Hannifin
Corporation, 230
with product bundling,
242–244
reaction of competitors,
246–247
at single price per unit
estimating profit-
maximizing price,
228–230
potential for higher profit,
231
profit maximization,
225–227
at Walmart, 281
Principal, 340
Principal-agent model, 476–481
basic consideration,
476–477
Du Pont plan, 481
employee’s effort problem,
477–479
implications, 480–481
optimal contract, 479–480
in performance evaluation,
504–505
Prisoner-of-war camps, 358
Prisoners’ dilemma, 214–216,
300, 323
Procter & Gamble Co., 131,
263, 272, 368, 384, 621
Producer surplus, 90–91, 658n
captured by superior assets,
273–276
market power vs. competitive markets, 269
and second-price auctions,
276
in value, 260
Producer transaction
costs, 261
Product attributes, effect on
demand, 138–139
Product bundling, 242–244
Product differentiation, 206
Product innovation, 117
Production
cumulative, 177–178
and efficient exchange, 90
profit-maximizing level,
179–180
specialization in, 71–74
by teams, 276–277
value creation in, 75, 268
vertical chain of, 282
Production functions
Cobb-Douglas, 158n
and cost curves, 170
fixed input proportions, 162
returns to a factor, 159–162
returns to scale, 158–159
substitution of inputs,
162–164
Production isoquants, 162–164,
192
Productivity
happy-is-productive model,
33–34
Product life cycle, 139–141
Product market, 605–606
Product-of-the-environment
model, 35
limitations of, 36
Product or geographic subunits
benefits of, 421
building of, 419–420
problems with, 421–422
Product quality, 263
Products
close substitutes, 195n
demand curves for, 122–123
demand elasticities for, 125
individual demand curves,
232–233
network effects and demand
for, 136–138
storable, 246
Profit
accounting profit, 197n
and CEO turnover, 106
economic profit, 197–200
Index 733
managerial objective, 106
reduced by competition, 201
and stock prices, 259n
Profitability codes, 17
“Profitability software,” in
banks, 17
Profitable customers, 17
Profit centers, 544
summary of, 547 Profit maximization, 106
and linear demand curves,
129–131
marginal analysis for,
179–180
by monopoly, 205
MR=MC, 195–196
and price objective, 224
at single price per unit,
225–227
Profit maximizing output level,
179–180
and factor demand curves,
181–183
in monopoly, 205
Profit-maximizing price,
estimating
cost-plus pricing, 228–229
importance of assumptions,
230
linear approximation, 228
markup pricing, 230
Profit potential
and barriers to entry, 270
higher, 231
Profusion, 584
Promotions, 452–454
Property rights, 68–75
alienability, 68, 69
defining and enforcing,
658–660
dimensions of, 69
gains from trade, 69–75
as incentive, 100–101
insecurity in Colombia, 70
and market economy,
68–75
Niger, 96
private vs. alienable, 68 use rights, 69
Prostitutes
demand declines in United
States, 140
Proton Holdings Bhd, 176
Prudential Insurance Company,
333
Prudential Securities, 199
Public Company Accounting
Oversight Board, 599
Public goods, 663
Public Health Service, 697
Publicly traded corporations,
580–582. See also Corporations
benefits of, 583–584
corporate form of
organization, 580
governance objectives, 582
stock exchanges, 581
stock ownership patterns,
581
Public utilities, 175, 664
Pucik, V., 526n
Purdue University, 696
Pure strategy, 306
Pure strategy equilibrium, 316
Q47, 563 Qian, J., 590n
Qian, M., 590n
Quaker Oats, 548
Qualified applicants, 446
Qualitative forecasts
supply and demand analysis
for, 79–80
Quality
by external monitoring, 699
Quantifiable performance
measures, increased use
of, 522
Quantity
versus price adjustments, 82–85
Quantity changes, causes of,
6–7
Quantity demanded
cross elasticities,
132–133
effect of price changes, 124
QuickBooks, 223
Quicken Deluxe, 242
Quicken software, 223–224, 242
Quick Motorcycle Company,
436–437
Quinn, Cheryl, 485
Quotas, 641
Qwest Communications, 261
Radford, R., 358 Rago, J., 33
Rai, S., 306
Raice, S., 441
Railroad companies, 624
Raith, M., 383n, 386, 508n
Ramstad, E., 41, 132n, 203
Rank-yank systems, 519
Ratchet effect, 506–507
Rate busters, 512
Raviv, A., 587n
Read, Ian, 266
ReaLemon Company, 136n
Real estate agents and
homeowners, incentive
problems between, 344
Realism, 38
Rebates, 241–242
Recall, General Motors, 687
Recognition industry, 485
Recruitment
of Iraqi soldiers, 445
Red Cross, 358
Reddy, S., 173
Reduced flexibility
specialized task assignment,
413
Refueling costs, 340
Regis Corporation, 176
Regression analysis, 184
Regulation
nonmarket transactions,
626–627
Regulatory issues
contracting with distributors,
641–642
Reilly, R., 147
Reingold, J., 516
Reishus, D., 593n
Related diversification, 284
Relative cost
of labor at SeaTac Airport,
167
Relative performance contract,
482
Relative performance
evaluation, 511–513
across-firm performance,
513
for CEOs, 512
potential costs of, 513
within-firm performance,
512–513
Relative price, 23
and income changes, 26–27
Relevant costs, 171
and profit maximization, 226
Religions, 687
Reneging, 519
Renting
and asset abuse, 629
Rents, 269n
Repeated interaction, 216
definition, 223
in teammates’ dilemma,
223–328
Repeated strategic interactions,
314–315
Repeat sales, 699–700
Repetitive transactions, 631
ReplayTV, 146
Republic Airways, 86
Reputation, established, 103
Reputational concerns
and contract compliance,
347–349
Reputation effects, as barrier to
entry, 202–203
Research and development
(R&D)
and executive turnover, 5
joint ventures, 266
on return on investment,
centralization and, 391
Reservation utilities, 440
Residual income, 546
Residual loss, 341, 342
Residual profits, 332, 333
distribution of, 333
Residual rights, 628
Resource allocation
contracting costs, 101–102
Resources
and capabilities, 286
categories of, 266
Restaurant concept, 272
Restricting entry, 675–678
Retail pharmacies, 173
Retail supercenters
input mix, 168
mix of people and machines
choice in, 168
Return on assets, 545–546
Return on capital, 548
Return on investment
and centralizing R&D, 391
Returns to a factor
illustration of, 161–162
law of diminishing returns,
160–161
total, marginal, and average
quantities, 159–161
Returns to scale, 158–159
Revenue centers, 543
summary of, 547 Rewards
from performance evaluation,
504
Reward system, 4, 365
Rhino automobiles, 638–641
Rhoades, C., 271
Ribstein, L., 608n
Ricardian rents, 269n
Rice, Bruce J., 699
Rice, Paula DeLong, 699
Rice Aircraft Company, 699
Rice University, 124
Richard D. Irwin, 356n
Richards, E., 525n
Rich Manufacturing Company,
185
734 Index
Riddell, C., 481
Rigas, John, 330, 562
Risk
measures of, 39–40
Risk-adjusted discount rates, 115
Risk-averse investors, 333
Risk-averse preferences, 41n
Risk aversion, 39–40, 583
and compensation, 41
definition, 39
on ownership incentive, 474
versus risk taking, 41 Risk-free interest rate, 114
Risk magazine, 11 Risk-neutral, 40, 475
Risk premium, 40–41
Risk sharing, 474–476
Risk-sharing standpoint, 476
Risk taking vs. risk aversion, 41 Rivalry, degree of, 271
Rivals, sequence of actions by,
313
Rivals’ dilemma, 300, 315
RJR-Nabisco, 329–330, 331,
338, 339, 340, 370
Roberts, J., 278, 356n, 366n,
374, 380n, 382, 386,
404, 416, 434, 480n,
495, 508n, 630n, 646
Robey, D., 356n
Robinson, P., 690
Robinson-Patman Act, 247
Rochester Motors, 69
Rock, S., 506n
Rockford Products Company,
346
Rodriquez, Joaquin, 591
Roediger, H., 335
Rollins, M., 212
Rolls Royce, 428
Romer, P., 119n, 268, 293
Romero, S., 70
Roosevelt, Theodore, 600
Root, Elihu, 600
Rosen, Benjamin, 400
Rosen, S., 447n, 452n, 598n
Rosenbloom, S., 135
Rosenthal, M., 503
Ross, I., 537n
Rowling, J. K., 237
Royal Ahold, 579
Royal Bank of Scotland, 369
Royal Dutch/Shell Group, 580
Royal Swedish Academy of
Sciences, 298
Rubin, P., 647
Rubinfeld, D., 219
Ruhr Valley, Germany, 181
Russian civil code, 590n
Ryall, M., 290n
Sabre Interactive, 656 Sahlstrom, Pekka, 380
Salary–fringe benefit mix
to attract employees, 461–462
choices, 457–463
compensation plans, 463
employee preferences,
455–457
employer considerations, 457
at Lincoln Electric, 460
and overtime, 459, 460
temporary and part-time
workers, 462
Sales, of Walmart, 257–258
Salomon Brothers’, 684–685,
686, 702
Salomon Smith Barney, 14, 15,
579
Samek, Steve, 574
Sam’s Clubs, 257, 258
Samsung, 616
Sanctions, from performance
evaluation, 504
Sandberg, J., 515
Sandberg, Sheryl, 367
Sandler O’Neill, 438–439
Santini, Mario, 71, 72n, 74n
Santos, T., 386
Sapienza, P., 369
Sarbanes-Oxley Act of 2002, 8,
579–580, 586,
606–608
and decision rights, 586
economic costs of, 607
SAS, 139
Satellite TV, 193–194
Schaefer, S., 293, 484n
Schatzberg, J., 290n
Schelling, Thomas, 298
Schering-Plough, 32
Scherreik, S., 520
Schmalensee, R., 5n, 270n,
650n
Schmelzle, G., 501
Schmittlein, D., 630n
Schoen, J., 622
Scholes, M., 333, 459n,
550n, 626n
School’s test scores, 491
Schrest, L., 142n
Schroeder, M., 643
Schwart, E., 637
Schwartz, Nelson D., 12
Schwartz, R., 142n
Scientific knowledge, 99
Scott, W. Richard, 36
Search engines, topic-specific, 99
Sears.com, 244
Sears Roebuck, 138, 281
SeaTac Airport, 167
Second-degree price
discrimination, 239
Second-highest valued use, 276
Second potential Nash
equilibrium, 313n
Second-price auctions, 276
Secure strategy, 309
Securities and Exchange
Commission, 513, 562,
585–586, 600–601, 685
on reducing contracting costs,
349
regulations, 657
rules on perquisites, 338
Securities trading, fraudulent,
11–12
Self-evaluation, 515
Self-interest, 705
Self-selection, 346, 446
Self-selection principle, 239
Selten, Reinhard, 298
Semco S.A., 519
Senate Commerce Committee,
305
Sensitivity analysis, 185
Severson, K., 491
Shanghai World Exposition of
2010, 156
Shanley, M., 293, 617n
Shapiro, C., 236n, 251, 450n
Shareholders, 586–591
decision authority of, 586–590
diversified, 41
incentives, 590–291
Shareholder value, and market
efficiency, 113–119
Share value, 114–116
Sharp Corporation, 277
Sharpe, W., 475n
Shaw, W., 687n, 689n, 712
Sheehan, D., 597n
Shell, 579
Shepsle, K., 374, 630n
Sherman Act, 1890, 664
Shevlin, T., 459n, 550n
Shiely, J., 537n
Shimek, Terry, 132
Shimek’s Audio Video,
Anchorage, 132
Shinseki, Eric, 540
Shirking
by employees, 504–505
Shirking among supervisors,
517–518
Shleifer, A., 581n, 590n, 591
Shontell, A., 367
Shortage
from lower price, 77
Short-run cost curves,
171–174
as operating curves, 171
Short-run costs, 184
Short-run effects, supply and
demand analysis, 85–86
Short-run marginal cost, 196
Short-run supply decisions,
195–196
Short-term contracts
vs. long-term contracts, 635 Shutdown condition, 196
Sidmar, 157
Siemens, 384
Silicon Valley, 266
Silver Airways, 86
Simmon, B., 171
Simon, H., 16n, 103
Simons, J., 137
Simulated market, 142
Simultaneous moves, 299–309
Singer, J., 153n
Singer, P., 689n
Singh, Vijay, 37
Site specificity, 622
Siu, J., 605n
Six Sigma program, 396
SK Global, 298
Skilling, Jeffrey, 1
Slade, M., 632, 646
Sleep Health Centers, 361
Sloan, Alfred, 381
Sloan, R., 5
Slope
of isoquant, 192
of linear curves, 22n
Small shareholders, 590
Smith, A., 413, 584, 689, 698
Smith, C., 143, 284n, 285n,
332n, 352, 456n, 483n,
549n, 590n, 597n, 628n,
630n, 634, 684, 712
Smith, D., 532n
Smith, R., 444n, 465
Snow, C., 426n
Snyderman, B., 33n
Sobel, J., 382
Social costs, 206n
Social media, 368
Social networks, 368
Social responsibility
economists’ view of,
693–695
Société Générale, fraudulent
trading at, 11–12
Solldac, 157
Solomons, D., 566
Song, H., 503
Sonic Corporation, 268
Sony Betamax format, 136
Index 735
Sony BMG Music
Entertainment, 249
Sony Corporation, 203, 243,
249, 348, 604, 616
Sony PlayStation, 348
Sotheby’s Holdings, 588
South Sea Company, 584
Soviet Union, 98
S&P, 600n
Spacek, Leonard, 572
Sparshott, J., 678
Special interest groups, 669
Special interests, and Microsoft
antitrust suit, 669
Specialization, 71–74
Specialized task assignment
Adam Smith on, 413
benefits of, 412
versus broad, 411–415 Delta Airlines versus China
Eastern Airlines, 414
comparative advantage, 412
coordination costs, 413
costs of, 412–413
forgone complementarities,
412
functional myopia, 413
incentive issues, 413–415
lower cross-training
expenses., 412
reduced flexibility, 413
Specific assets, 102
as barrier to entry, 202
and procurement
decision, 631
and uncertainty, 631
and vertical integration,
629–632
Specific human capital,
443–444
Specific knowledge, 98–100
assembled, 99–100
dynamic nature of, 99
and economic systems, 100
versus general knowledge, 98–100
idiosyncratic, 99
scientific, 99
transfer costs, 98
transfer of, 98
Spindle, B., 280
Spitzer, Eliot, 422
Sports magazine, 410 Spot market, 619
Springsteel, I., 551
Sprint PCS, 212
Standard deviation, 39–40
Standard Oil, 281
Standard-rating-scale systems,
515–516
Standard supply and distribution
contracts, 618
Starvish, M., 524
Stated income loans, 6
Statistical analysis, for demand
estimation, 143–145
Steel, global demand for,
156–157
Steel prices, 89, 156–157
Steel production, 181
Stein, G., 422
Stein, R., 691
Stenberg, J., 441
Stern, J., 537n
Stewart, B., 548, 566
Stewart, Martha, 688
Stigler, George, 7n, 148, 187,
219, 283n, 450, 671n,
691n
Stiglitz, J., 450n
Stock analysis
flawed, 14–15
utility function of, 28–30
Stock analysts
optimal choices, 29, 30
Stock exchanges, 581
Stocklifting, 300
Stock market efficiency,
116–117
Stock market values, 105
Stock prices, 143
anticipating abnormal profits,
259n
Apple computer, 248
reaction to news event, 117
Stock(s)
constant growth model,
115–116
granting options, 483
“killer B,” 588
options to motivate
executives, 488
ownership patterns, 581
of Walmart, 257–258
Stock valuation, 115
Stohr, G., 235
Stole, L., 413n
Stoller, G., 262
Storable products, 246
Store layout, 138
Strategic, meanings of, 297n
Strategic alliances, 618
Strategic behavior, NHL labor
disputes, 314
Strategic business planning
vs. gains from trade, 72 Strategic decision making, 259
Strategic form, 299
Strategic interaction,
297–298
and organizational
architecture, 316–318
Strategic moves, 312–313
Strategic thinking, 208
Strategy, 258, 423–424
business strategy, 258n
for capturing value, 269–282
corporate strategy, 258n
determinants of, 360–361
economics of diversification,
282–286
in face of changes, 281
important questions for, 258n
increasing demand, 262–265
at Lincoln Electric, 502
and market power, 270–272
meanings of, 297n
for new products/services, 265
production costs, 261
superior factors of
production, 273–277
as systems of complements,
278
transaction costs, 261–262
for value creation, 259–269
at Walmart, 278–280
Strategy formulation
environmental and internal
analysis, 287–288
and organizational
architecture, 288
understanding business
environment, 286–287
understanding resources and
capabilities, 286
Strategy planning framework, 287
Strauss, Thomas, 684
Strom, S., 694
Stuart, S., 8
Stuckey, J., 630, 630n
Stulz, R., 285n, 492, 587n
Subgame perfection, 313n
Subjective performance
evaluation, 513–514
combined with objective
evaluation, 520–521
and decision rights, 513
holistic view of employee’s
performance by, 514
job dimensions, 513
methods, 515
frequency of evaluation, 517
goal-based system, 516–517
standard-rating-scale
systems, 515–516
multitasking and unbalanced
effort, 514–515
problems with
forced distributions,
518–519
influence costs, 519
reneging, 519
shirking among
supervisors, 517–518
self-evaluation, 515
tips on, 520
Submarkets, 235
Subprime mortgage crisis, 6
Subrahmanyam, M., 332n
Substitutes, 22
close, 195n
determinant of price
elasticities, 127
effect on demand, 131–132
market power and threat of, 271
price of, 265
Substitution, 162–164
Substitution effect, 54–57, 123n
in choice of inputs, 167–168
magnitude of, 57–59
Sugar prices, 273
Suhr, J., 691
Sullivan, Louis H., 360
Sullivan, M., 550
Sullivan, Scott, 596
Sunk costs, 17, 623
Sun Microsystems, 655, 669
Supercuts, 176
Supplier power, 271
Supply
effect of shift in, 77
long-run decisions, 196–197
short-run decisions, 195–196
Supply and demand analysis
for European investment
bankers, 440
extended analysis
Coase theorem, 95–98
efficient exchange and
production, 90
externalities, 95–98
gains from trade, 90–91
government intervention,
91–95
industry cost and price
adjustments, 86–90
price controls, 92–93
price floors, 93–94
price versus quantity adjustments, 82–85
short-run versus long-run effects, 85–86
linear, 80–82
of marketplace, 274
price mechanism, 76–78
for qualitative forecasts, 79–80
shifts in curves versus movements along
curves, 79
supply of pilots, 86
736 Index
Supply curve
business strategy, 259–260
versus movements along curves, shifts in, 79
and price mechanism, 77
Supply of regulation, 669–670
Surplus, from higher prices, 77
SUVmart, 638–641
Synchem, 563
Tabuchi, H., 133 Taco Bell, 8
Tagliabue, J., 296n
Taiwan Semiconductor
Manufacturing Co.
vertical outsourcing by, 619
Takeuchi, H., 117n
Tandy, 669
Tangible assets, 266
Tanzi, Calisto, 602
Target Corporation, 173, 258,
281, 390
Target returns and volume, 229
Tariffs
on sugar imports, 273
Task assignment. See also Jobs and decision Rights, 378–380
at FinWare, 411–415
productive bundling, 415–416
specialized
Adam Smith on, 413
benefits of, 412
versus broad, 411–415 comparative advantage, 412
coordination costs, 413
costs of, 412–413
forgone complementarities,
412
functional myopia, 413
incentive issues,
413–415
lower cross-training
expenses, 412
reduced flexibility, 413
Tattoos, 457
Taubman, Robert, 588
Tavernise, S., 445
Taxes/taxation
and corporate philanthropy,
692
and nonmarket transactions,
626–627
Tax Executives Institute, 665
Taxi licensing, 667
Taylor, Frederick Winslow,
366n, 430
Taylor, L., 44
Teachers
and student test scores, 491
Team decision making
benefits of
employee buy-in,
394–395
improved use of
knowledge, 394
costs of
collective-action problems,
395
free-rider problems, 395
management implications,
395–396
effeciveness, 396
optimal team size, 396
Teammates’ dilemma,
323–328
Team output, 522
Team performance, 521–522
evaluating teams, 524–525
team production, 522
Team production
ownership incentive and,
474
Team production capabilities,
276
difficult to duplicate, 276
and flexible manufacturing,
278
and organizational
architecture, 277
at Sharp Corporation, 277
Teams
decision rights assignment to,
394–396. See also Team decision making
definition, 394
evaluation of, 524–525
formation of, 521
at Nucor versus Levi Strauss, 396
peer pressure within,
523
reasons for failure, 524
Technology
in business environment,
286–287
control and, 362
coordination problems, 305
and decentralization, 391–393
and nonmarket transactions,
627
to reduce monitoring costs,
340
rejuvenates U.K. Auto
Producers, 428
and value creation, 265
Telecommuting, 498,
500–501
application, 500–501
costs and benefits, 501
Telser, L., 635n, 699n
Temporary employee agencies,
657
Temporary workers, 462
Ten Commandments, 687
Tenneco, 285
Tergesen, A., 501
Terrorist attack of 2001, 2
effect on airlines, 296–297,
417
effect on consumer
transaction costs, 262
effect on demand curve, 137
effect on labor demand, 183
Terry, R., 594n
Texaco, 281
Texas Instruments, 619
Textile industry competition,
271
Third-degree price
discrimination, 237
Third-party monitors, 700
13D filings, 591
Thornton, E., 376n, 450
3M Corporation, 124
Thyssen, 157
Tianjin Optical & Electrical
Communication Group,
10
Ticket prices (movies), 627
Tiffany & Co., 699
Time and motion studies, 506
Time factor
in price elasticities, 128
in short or long run, 171
Time Inc., 193, 410–411
Time magazine, 410 Time versus money, 31 Time Warner Cable, 462, 562
Tipping, in restaurants, 363
Tirole, J., 5n, 382n, 386, 416,
556n, 566, 650n
Tit-for-tat strategy, 325–327
TiVo, 146
Tmall (Alibaba), 701
Toffler, B., 712
Tokyo Metropolitan Police Lost
and Found Center, 34
Tokyo Mitsubishi, 579
Tokyo Stock Exchange, 581
Topel, R., 517n
Topic-specific search engines,
99
Top management, 594–598
authority, 594–596
incentives, 597–598
Toshiba, 277
Tosoh Corporation, 317
Total cost, and cost-plus pricing,
228–229
Total cost curve, 169, 170, 172
Total product, 159–162
Total quality management, 396
Total revenue
and linear demand curves,
129
and price changes, 127
Total value, 260
Total variable cost, 172–173
Towers Perrin Company, 469,
601–602
Toyota Motor Corporation, 8,
376, 580
Toys “R” Us, 28, 390
Trademark protection, 659
Trade-offs
architecture within firms,
359–360
between decision
management and
decision control,
561–564
economic, 411
economic analysis, 33
faced by individuals, 18
between functional and
product or geographic
subunits, 420–423
and homogenous consumers,
233
illustrating, 385–389
and indifference curves,
21–22
money for other things, 31
between nonmarket
transactions, 627–635.
See also Vertical integration
and sunk costs, 18
Training
local managers, 381–382
Transaction-Cost Theory, 632
Transactions, reducing number
of, 102
Transfer prices, 331
Transfer-price test, 626
Transfer pricing, 549–560
with asymmetric information,
552–556
common methods
full-cost, 559
marginal-cost, 557–558
market-based, 556–557
negotiated, 559–560
with costless information,
551–552
dual systems, 551
economics of, 550–556
reorganization, 560
and taxes, 550
Index 737
lagging in worker skills, 443
United Technologies, 377
Universal Music Group, 249
Universities
influence costs in, 454
pay in, 454
University of Notre Dame, 124
University of Richmond, 124
Unprofitable customers, 17
Unrelated diversification, 285
Upstream integration, 618
Ursinus College, 124
U.S. airlines
lack of profitability, 173
U.S. Department of Agriculture,
697
U.S. Department of Justice, 315,
330, 579, 588, 626–627,
655, 656, 664, 685
U.S. Department Veterans
Affairs, 540
U.S. Food and Drug
Administration, 691, 695
U.S. law, 697
U.S. Mint, 19
U.S. securities laws, 666
U.S. Sentencing Commission,
704
U.S. steel industry, 678
U.S. Supreme Court
rules in favor of selling
imports of copyrighted
items, 235
U.S. tax code, 526
U.S. tobacco industry, 272
Used car market, 347
U-shaped cost curves, 170
Utility, 20
and slope of indifference
curve, 50–51
Utility function, 20–21
and indifference curves,
21–22
of stock analysis, 28–30
Utility functions
forms of, 49
ordinal vs. cardinal ranking, 49
Utility maximization, 20n, 52
Utility-to-price ratio, 52, 53
V.A. hospitals performance measures, 540
Valdmanis, T., 422
Value, capturing, 269–282
ability of firms, 290
in face of change, 281
failure by Eli Whitney, 270
market power, 270–272
Polaroid’s success and failure,
282
superior factors of
production, 273–277
Walmart’s success, 278–280
Value, consumer and producer
surplus, 260
Value creation, 259–269
by converting organizational
knowledge, 266–267
cooperation for, 265–266
demand and supply curves,
259–260
by diversification, 285
by Eli Whitney, 270
gains from trade and, 75
general means of, 260
by increasing demand,
262–265
from new products/services,
265
opportunities, 267–269
reducing consumer waiting
time, 261
reducing production costs,
261
by reducing transaction costs,
261–262
from technology, 265
total value, 260
Value maximization, 282, 349
ethics and, 690–692
compensating differentials,
691
economic Darwinism, 690
role for regulation,
690–691
Vancil, R., 453, 596n
Van Horn, L., 636
Variability, 39
Variable costs, 172
retail pharmacies, 173
Variables influencing demand,
135
Varian, H., 236n, 251
Variance, 39
Variety of tasks, 378
Vasella, Daniel, 492
Vellequette, L., 315
Verbal contracts
CEO’s view of, 703
Verizon Wireless, 212
Vertical chain of production,
282, 617–619
for personal computers,
617–618
Vertical integration
in aerospace industry, 632
to avoid contracting with
competitors, 634
versus long-term contracts, 627–635
asset ownership, 632–633
continuum of choice,
634–635
incomplete contracting,
628
other reasons, 633–634
ownership and investment
incentives, 628–629
specific assets,
629–632
and price-discrimination,
625–626
Vertically integrated firms, 618
Videocassette recorders, 146
Videogames, 243
Vinson, Betty, 606
Violations
insider-trading, 688
Virgin Atlantic Airlines, 261
Virtual vineyards, 237
Virtue, 689
Vishny, Robert W., 590n, 591
Vision Technologies, 137
Vivendi Universal, 249
Voluntary corporate liquidation,
290n
Voreacos, D., 137
V-8 vegetable juice, 18
W. L. Gore & Associates, 516
Wages
compensating differentials,
444–446
efficiency, 449–450
information about market
rates, 446
and job risks, 445
minimum, effect on
employment, 167
Waigaya, 376 Wakeman, L., 628n, 700
Waksal, Samuel, 688
Walczak, L., 671
Walgreens, 173, 691
Walker, M., 308
Wall Street Journal, 133, 203, 279, 578, 606, 669,
698, 700
Walmart, 235, 281, 390, 393,
537, 580
diversification by, 283
explanation of success,
278–280
first-mover advantages, 312
focus of strategy, 258–259
holiday season 2007, 281
738 Index
Transportation costs, 175–176,
629
reduced by Ford and General
Motors, 283–284
reduced by Internet, 262
Transportation Security
Administration, 417, 686
Travelers Insurance Company,
685
Treasury note auction,
684–685
Tredwell, Jay, 551
Trilogy Software, 41
Tucker, R., 675
Tuition pricing, 236
Tully, S., 137, 588
TurboTax, 223, 240, 244–245
Two-part pricing, 641
Two-part tariff, 233–234
for capital goods, 235
Tyco International, 579, 609,
694
scandal, 8
Tying arrangements, 248
Tylenol tragedy, 708–709
U. S. Navy, 637 UBS, 89, 384, 579
Ujiie, Junichi, 280
U.K. Auto Producers
new technology rejuvenates,
428
Ulhoi, J., 426n
Uncertain environments, 630
Uncertainty
asset specificity and, 631
decisions making under,
38–41
Underhill, Paco, 138
Unilever, 272, 306
Unions
and vertical integration and
contracting, 633
Unitary demand, 127
Unitary form (U form) of
organization, 417
Unit cost, 169
United Airlines, 201, 208, 212,
247, 297, 333
online pricing errors, 123
United Banker’s Bank, 634
United Cigar Stores, 263
United Parcel Service, 271,
462, 583
United States
animosity toward Venezuela,
70
demand for prostitutes in, 140
Global Entry Program, 262
international locations, 279
online pricing errors, 123
reduced transaction costs,
261–262
rural-urban differences, 279
strategy, 257–258
supercenters and demand
elasticities for grocery
products, 125
Walmart.com, 289–290
Walt Disney Company, 137
Walton, Sam, 257, 278
Wants, 15
War, and hunger, 659
Warburg Asset Management, 684
Warehouses (Amazon), 158
Warnaco, 400
Warner, J., 370n
Warner, M., 137
Warner Brothers, 217
Warner Music, 249
Warranties, 700
Washington lobbyists, 671
Washkewicz, Donald, 230
Watts, R., 370n, 401, 557n,
595n, 597n, 675
Wealth constraints on ownership
incentive, 474
The Wealth of Nations, 413, 584 Wealth transfers, examples of,
667–668
Webb, E., 142n
Weisbach, M., 370n, 594n,
597n
Welch, Jack, 519
Wells Fargo, 281
Wendy’s, 261, 267, 696
Werhane, P., 711
Wessel, D., 417
Western coal producers, 678
Weston, J., 587n, 605n
Wexler, C., 193n
Whinston, M., 647
Whitacre, Mark, 217
Whitford, D., 282, 438n
Whitney, Eli, 270
Widely held corporation, 581
Wilke, J., 655n
Williams, M., 348, 376n
Williamson, O., 5n, 107, 422n,
434, 622n, 632, 647
Willig, R., 5n, 270n
Wilmorite Corporation, 693
Wilson, George, 691
Wimbledon tennis tournament,
308
Windows computers, 138
Wingfield, N., 246
Wireless phone companies,
212
Within-firm performance,
512–513
Wolfson, M., 333, 459n, 550n,
626n
Wooders, J., 308
Woodruff, D., 376n
Woodruff, Michael, 336
Worker Safety Rules, 680
Workforce skills, 443
Workplace, comparative
advantage in, 75
Work sampling, 506
World Acceptance Corp., 31
WorldCom, 8, 14, 578–579,
583, 584, 586, 589, 592,
596, 606
World Motors (WM), 680
World Trade Center attack, 137,
262
Wrigley, A., 157n
Wrong behaviors, 687
Wruck, K., 370n
Wu, J., 600n
Wulf, J., 396, 419, 431
Xbox One, 616 Xerox Corporation, 9, 247–248,
281, 286, 297, 363, 370,
400, 485, 643
Xie, J., 514n
Xoceco Inc., 203
Yahoo!, 99 Yellen, J., 450n
Yermack, D., 592n
Yohe, G., 127, 133, 134
Young, G., 503
YouTube, 629
Zantac, 550 Zellner, W., 290
Zero economic profit, 207–208
Zhang, I., 607
Zhang Bengjun, 10
Zimmerman, J., 5n, 401, 549n,
559n, 560n, 566,
675, 684
Zingales, L., 369
Zwiebel, J., 413n
Index 739
A bsolute performance evaluation is based on a predetermined standard of performance—see relative- performance evaluation.
activity-based costing (ABC) assigns different categories of overhead (purchasing, engineering, inspection) costs to
products by first estimating the underlying cost drivers of
the activities performed within the overhead department
and then assigning these activity costs to the products that
benefit from or consume these resources.
adverse selection refers to the tendency of individuals with private information about factors that affect a potential trading
partner’s benefits to make offers that are detrimental to the
trading partner—see precontractual information problems.
agency relationship is an agreement under which one party, the principal, engages another party, the agent, to
perform some service on the principal’s behalf.
alienable property rights are private property rights that can be transferred (sold or given) to other individuals.
arbitrage is a simultaneous set of transactions designed to make profits without risk (for example, if equivalent assets
are traded in two markets, buying at the lower price and
selling at the higher price).
arc elasticities are estimated between two points (elasticities also can be calculated at a point); they relate
the percentage change in one variable, such as quantity, to a
percentage change in another variable, such as price.
asset specificity occurs when a given asset is especially useful to one or to a small number of buyers—for physical
assets, this results from product design or site specificity; for human capital, it results from investments in specialized knowledge or skills.
asymmetric information occurs when one party to a transaction has information different from that of another
party.
audit committee is a committee of the board of directors responsible for oversight of the financial reporting process,
selection of the independent auditor, and receipt of audit
results.
G-1
average cost (AC) is the total cost divided by total output; average cost can be defined for either the long run or the short run.
average product (AP) of an input is the total product divided by the quantity of the input employed.
average revenue (AR) is the total revenue divided by total output.
Backward integration occurs when an organization produces its own inputs—also called upstream integration.
bargaining failures occur due to asymmetric information; parties fail to reach an agreement, even when in principle
a contract could be constructed that would be mutually
advantageous—see precontractual information problems.
barriers to entry are factors that limit the entry of new firms to a market, even though the existing firms are making economic profits.
benchmarking is identifying the best practices of firms operating within similar environments, so that the
benchmarking firm can learn from the experience of the
others.
Bertrand model examines producer interaction, assuming each firm treats the product price chosen by its competitors
as fixed and then decides how to set its price—see
oligopolistic market.
blockholder is a name given to the holder of a “large” amount (at least 5 percent of the outstanding shares) of
common stock.
block pricing sets a high price for the first unit or block of units purchased and lower prices for subsequent units or
blocks.
boundary setting occurs when managers empower employees to make decisions within prespecified limits.
brand-name capital refers to a firm’s intangible reputational capital; by establishing a reputation for quality
products or living up to its end of a contract, the firm can
receive more favorable terms from contracting parties
because it is a more desirable partner.
Glossary *
*Italicized terms are defined elsewhere in the glossary.
G-2 Glossary
broad task assignment has individual employees performing a relatively large set of tasks—see specialized task assignments.
bundling occurs when a company packages two or more products together and offers the package for sale as a unit.
business environment includes the technology, markets (product and input), and regulations facing the firm.
business ethics is the study of behaviors that businesspeople should and should not follow (however, this term also is
used in a variety of ways that range from making firms socially responsible to attempting to induce employees to
ignore their self-interest).
business judgment rule states that in the absence of bad faith or some other corrupt motive, directors are normally
not liable to the corporation for mistakes of judgment. The
rule has functioned as a barrier to prevent courts from
exercising regulatory powers over the activities of corporate
managers.
business norms are expectations in market transactions that do not have the force of law, yet nonetheless represent
expected behavior.
business strategy focuses on strategy at the business-unit level; the primary consideration is whether to focus on being
the low-cost producer in an industry or to develop
differentiated products for which customers are willing to
pay a price premium.
C corporations are the most common form of organization among large companies; income faces double taxation; shareholders have limited liability; there are few restrictions on the number or type of shareholders that can
own stock in the firm—see S corporations.
cafeteria-style benefit plans are plans in which individual employees allocate a fixed-dollar fringe-benefit allowance among a variety of choices—also called menu plans.
career earnings are the total wages that employees expect to earn over their entire careers.
cartels consist of formal agreements among a set of firms to cooperate in setting prices and output levels.
centralized decision system is one that assigns the most important decisions to senior executives within the
organization.
certainty equivalent is the certain income that an individual considers equivalent to an activity with risky
payoffs.
changes in demand are movements of the demand curve motivated by factors other than changes in the good’s own
price (such as changes in income or changes in the prices of
related goods).
changes in the quantity demanded are movements along a demand curve that are motivated by changes in the good’s own price, holding all other factors constant.
civil law is based on a series of written codes or laws and constitutes the basis for the legal systems in various
countries such as Germany and France.
closely held corporations are characterized by stock that is not freely traded and often held by only a few shareholders
(often within the same family).
Coase Theorem states that the ultimate resource allocation will be efficient, regardless of the initial assignment of
property rights, as long as contracting costs are sufficiently low, property rights are assigned clearly, and these rights can be exchanged readily.
common law is unwritten law developed primarily from judicial case decisions based on custom and precedent. It
developed in England and constitutes the basis for the legal
systems of most of the states in the United States.
common stock represents equity claims held by the “residual owners” of the firm. They are the last in line to
receive any distribution of earnings or assets.
comparative advantage occurs when one party can produce a good relatively more efficiently than other
parties (relative efficiency means that alternative products
which could have been produced from the same inputs are
less valuable). It is conceptually possible for a party to
have an absolute advantage in producing all goods
(meaning that it can produce all goods with fewer inputs);
however, it cannot have a comparative advantage in all
goods. Aggregate output is higher if parties specialize in
producing products in which they have a comparative
advantage.
compensating wage differential is the extra wage that is paid to attract an individual to a less desirable job.
competitive market is a market structure in which no buyer or seller has market power (all trades are made at the going market price); it is characterized by a large number of potential buyers and sellers, low costs of entry and exit,
product homogeneity, and rapid dissemination of accurate
information at low cost.
complementarities exist when doing more of one activity either increases the benefits or reduces the costs of doing
another activity.
complements are products that tend to be consumed together; a price reduction of one good tends to increase the
quantity demanded of the other good.
complete contracts are contracts that specify exactly what is expected of each party under all possible future
contingencies.
Glossary G-3
constant returns to scale for a production function occur when a 1 percent change in all inputs results in 1 percent
change in output.
consumer surplus is the difference between the maximum amount a consumer would be willing to pay for a product
and what the consumer actually pays when buying it.
contracting costs are the out-of-pocket and opportunity costs of negotiating, drafting, and enforcing contracts; they include search and information costs, bargaining and
decision costs, and policing and enforcement costs, and the
efficiency losses that result because incentive conflicts are
not completely resolved.
contracting problems occur within contracts because individuals have incentives to take actions that increase
their well-being at their contracting partner’s expense; they
occur within both explicit and implicit contracts.
control system encompasses the reward and performance evaluation systems within the firm.
corporate culture is the set of explicit and implicit expectations of behavior within the firm; it usually encompasses the ways work and authority are organized,
the ways people are rewarded and controlled, as well as
organizational features such as customs, taboos, company
slogans, heroes, and social rituals.
corporate governance is a popular term that is used to describe organizational architecture at the top of a
corporation. Corporate governance focuses on the
allocation of decision rights among the shareholders, board
of directors, top managers, and various external monitors
(e.g., independent auditors, stock exchanges, governmental
regulators, and financial analysts) and the associated
incentives of these parties. Corporate governance also
encompasses the type and frequency of information
corporations must disclose to various constituents.
corporate stakeholders is a term used to describe employees, banks, customers, communities, and other
parties that are affected by the operations of a corporation.
corporate strategy focuses on strategy at the firm level; the primary consideration is the degree of corporate
diversification chosen by the firm (the array of different
products that the firm sells).
corporation is a legal form of organization formed by filing the appropriate paperwork and fees with officials in the state
of incorporation; has the legal standing of an individual
(distinct from its shareholders) and can enter contracts,
participate in lawsuits, and so on; corporations also have the
right to issue stock and to exist indefinitely; shareholders have
limited liability—see C corporations and S corporations.
cost centers are business units whose performance is evaluated based on their efficiency of production.
cost-plus pricing is where firms set prices by marking up average total cost by an amount designed to yield a target
rate of return.
Cournot model examines producer interaction, assuming each firm treats the output level of its competitors as fixed and then decides how much to produce—see oligopolistic market.
credit rating agencies rate the publicly traded debt of corporations in terms of the probability of default
(e.g., Fitch, Moody, and Standard and Poor’s).
cross elasticity relates the percentage change in the quantity of a good purchased to a percentage change in the
price of some other good.
cross-training occurs when employees are taught to complete more than one task or function.
cumulative production is the total output produced by the firm across all previous production periods.
Deadweight loss involves the forgone gains from trade (for instance, the forgone producer and consumer surplus when a firm with market power sets price above marginal cost).
decentralized system is one that assigns many important decision rights to lower-level employees.
decision control encompasses the ratification and monitoring of decisions.
decision management encompasses the initiation and implementation of decisions.
decision rights represent the authority to decide how resources will be used within the organization.
decreasing returns to scale for a production function occur when a 1 percent change in all inputs results in a less
than 1 percent change in output.
dedicated assets are those whose purchase is necessitated by the requirements of one or only a few buyers.
demand curve displays the relation between the quantities of a product that will be purchased at each price over a
stated period of time, holding all other factors fixed;
demand curves slope downward because customers are
more likely to purchase if the price is lower—see law of demand.
demand function is the relation between the quantity demanded for a product and all factors that influence
its demand.
dominant strategies exist when it is optimal for a firm to choose a particular strategy no matter the choices of its rivals—especially used in game theory.
G-4 Glossary
double markups are the increments in the product’s price above marginal cost first by the manufacturer and then by the distributor; this problem occurs with
decentralized pricing decisions when the producer has
market power.
double taxation refers to the case with C corporations where income is taxed both at the corporate level when
earned and at the personal level when distributed to the
owners (shareholders).
downstream integration—see forward integration.
dual-class shares are common stock shares issued for a single company with varying classes indicating different
voting rights.
duopoly is a market setting in which two firms compete in a market—see oligopolistic market.
Economic Darwinism is the economic counterpart of the biological theory of natural selection; an organization
selects features that increase its ability to survive within its
environment; the basic idea is that a competitive
marketplace creates pressures that favor organizations that
are relatively most efficient.
economic profit is an above-competitive (or extra-normal) rate of return on assets; economic profits are eroded in competitive markets.
Economic Value Added (EVA—registered trademark of Stern Stewart) is a measure of residual income; it is the after-tax operating profit of the division minus the total
annual cost of capital invested in the division.
economies of scale occur in industries in which average cost declines over a broad range of output levels.
economies of scope occur when the cost of producing a set of products jointly within one firm is lower than the cost of producing the products separately across independent firms.
efficiency wages are wage premiums paid to reduce shirking because employees are afraid that if they are
caught, they will be fired and lose this premium; efficiency
wages also discourage employee turnover.
elastic demand occurs when the price elasticity is greater than one; in this case, a small increase in price decreases
total revenue.
elasticity of demand relates the percentage change in the quantity demanded to a given percentage change in its price. Higher price elasticities mean greater price
sensitivity. Although the law of demand implies that this ratio will be negative, convention dictates that this elasticity
is stated as a positive number—also called price elasticity of demand.
equilibrium refers to a stable situation where no party has a reason to change its strategy (for example, in a competitive market, this occurs when the quantity supplied of a product equals the quantity demanded).
ethics is the study of behaviors that people should and should not follow.
exclusive territories grant individual distributors the exclusive rights to operate within a specified market area.
expense centers are business units that are given fixed budgets and asked to maximize some hard-to-measure
service or output; it is essentially a cost center that does not produce an easily measurable output.
experience goods are those that must be tried by the customer to ascertain quality.
explicit contracts are formal written agreements with a party related to the firm (for example, employees, customers, suppliers, and capital providers).
externalities are costs of or benefits from the actions of one party that affect the utility or production possibilities of another party.
Factor-balance equation states that at the cost- minimizing level of output, the ratios of marginal product to price for each factor are equal.
factor demand curves display the relation between the quantity of an input the firm demands and its price, holding other factors constant.
firm is a basic organizational unit of production; for purposes of this book, it is a focal point for a set of
contracts.
firm-specific assets are assets that are significantly more valuable in their current use within the firm than in their next best alternative use outside the firm.
first-degree price discrimination—see personalized pricing.
first-mover advantages are the expected benefits derived by the first firm to introduce a product.
fixed costs are those costs that do not vary with output over the time horizon of the analysis.
formal authority is the power that comes from explicitly assigned decision rights within the organization.
for-profit organizations have owners (for example, shareholders) who have title to the residual profits of the
organization—see nonprofit organization.
forward integration occurs when the firm begins to conduct additional finishing work or to market its own
goods—also called downstream integration.
Glossary G-5
franchise agreements are contracts between the franchisor (parent) and the franchisee that grant to the franchisee the
rights to use the parent’s name, reputation, and business
format at a particular location or within a stipulated market area.
free cash flow problems are incentive conflicts between owners and managers over retaining cash within the firm beyond that necessary to fund value-increasing investment
projects; managers prefer to take projects which expand
firm size beyond that which maximizes the firm’s value,
rather than to distribute the cash to owners.
free-rider problems occur in team efforts; each member of the team has an incentive to shirk because each
receives the full benefit from shirking, but bears only a
part of the costs.
fringe benefits are components of the compensation package other than salary and incentive compensation;
they are either in-kind or deferred (such as medical insurance and pensions).
full-cost transfer prices use full cost to value goods exchanged between business units; full cost is the sum of
fixed and variable cost.
function refers to a primary activity within the process that a firm employs to provide a product to customers; major functions include research, manufacturing, finance,
marketing, sales, and service.
functional myopia occurs when employees focus on their individual function at the expense of the larger array of activities that must be accomplished to capture as
much value as possible given the firm’s business
opportunities.
functional subunits group all jobs performing the same function into the same department.
Gain from trade is the difference between the minimum value that an owner or a supplier is willing to
accept for an item and the maximum price that a
prospective buyer is willing to pay.
game theory is concerned with the general analysis of strategic interaction; it focuses on optimal decision making
when all decision makers are presumed to be rational, with
each attempting to anticipate the likely actions and
reactions of its rivals.
general human capital consists of training and education that is useful across a wide variety of different firms.
general knowledge is that which is relatively inexpensive to transfer.
general partnerships are unincorporated businesses with two or more co-owners.
Generally Accepted Accounting Principles (GAAP) are that set of accounting methods commonly used or
proscribed by the Securities and Exchange Commission
(SEC) and the Financial Accounting Standards Board
(FASB) for financial reporting.
goal-based system provides each employee a set of goals for the year and then evaluates employees based on the
extent to which the goals are achieved.
going private transaction is a term used to describe reorganizations where a publicly traded corporation converts to a closely held corporation.
group incentive pay bases employee compensation on group performance.
group pricing occurs when a firm separates its customers into classes and sets different prices for each class—also
called third-degree price discrimination.
Historical costs reflect the original purchase price of resources and not necessarily their current opportunity cost; historical costs generally are not relevant for decision
making (except for their tax effects).
holdup problems can occur when parties invest in specific assets; for example, after the investment is made, the buyer might be able to force a price concession, since it will be in
the interests of the seller to continue to operate as long as
variable costs are covered.
horizon problems are the incentive conflicts that can arise between owners and employees due to differential horizons
with the firm; employees’ claims on the firm generally are tied to their tenure with the firm, but owners are interested
in the present value of the entire stream of future cash
flows.
horse race is a model used by some companies for top management succession. A pool of internal candidates
compete to replace the CEO. The “winner of the contest”
becomes the new CEO when the existing CEO retires.
human asset specificity—see specific human capital and asset specificity.
human capital is a term that characterizes individuals as having a set of skills that can be “rented” to employers.
Identification is a statistical problem that arises in separating the effects of simultaneous equations; for
example, separating supply versus demand shifts in
explaining the observed changes in market prices and
quantities.
implementation rights involve the execution of ratified business decisions.
G-6 Glossary
implicit contracts consist of promises and shared understandings that are not expressed by formal legal
documents.
incentive coefficients are weights that the compensation plan places on the various tasks assigned to an employee.
income elasticity relates the percentage change in the quantity purchased for a good to a given percentage change
in income.
incomplete contracts do not specify actions under all possible contingencies.
increasing returns to scale for a production function occur when a 1 percent change in all inputs results in a greater
than 1 percent change in output.
indifference curves display all the combinations of goods that yield the same utility.
individual proprietorships are unincorporated businesses owned by individuals.
industry demand curve relates total quantity demanded across all firms in an industry to price of the product.
inelastic demand occurs when the price elasticity is less than one; in this case, a small increase in price raises total revenue.
inferior goods are goods for which the quantity purchased declines with income.
influence costs include those nonproductive activities in which employees engage to influence decisions.
information failures refers to the case where information asymmetries and adverse selection can lead to a breakdown of markets and the failure to consummate potentially
beneficial exchanges.
informativeness principle states that it is typically desirable to include in the compensation plan all
performance indicators that provide incremental
information about the employee’s effort, assuming the
measures are available at low cost.
initiation rights are the decision rights to generate proposals for particular business decisions such as resource
utilization or contract structure.
internal labor markets fill jobs from within the firm. In firms that rely primarily on internal labor markets, they are
used to fill most non-entry-level jobs; employees typically
spend a significant fraction of their careers with the firm.
investment centers are business units that have all the decision rights of cost centers and profit centers as well as the decision rights over the amount of capital to be invested.
isocost lines display all combinations of the factors of production with the same cost.
isoquants display all possible ways to produce the same quantity (iso meaning “the same,” quant from “quantity”).
Jobs define the basic roles and responsibilities of employees; jobs have at least two important dimensions:
the variety of tasks that the employee is asked to complete
and the decision authority that is granted to the individual
to complete the tasks.
joint ventures establish new firms that are owned jointly by two or more independent firms.
just-in-time production (JIT) is a production system whereby each component is produced immediately as
needed by the next step in the production process.
Keiretsu is a form of network organization employed in Japan; it consists of an affiliation of quasi-independent
firms with ongoing, fluid relationships; typically, the firms have cross-holdings in each other’s common stock.
L aw of demand states that normal demand curves slope downward to the right—quantity demanded varies
inversely with price.
law of diminishing returns states that the marginal product of a variable factor will eventually decline as the use of the factor is increased—also called the law of
diminishing marginal product.
leadership is the process of persuasion or example by which an individual induces a group to pursue objectives
held by the leader; it has at least two important
components: establishing goals and motivating others.
learning curves display the relation between average cost and cumulative production; learning-curve effects refer to average cost falling as production experience accumulates.
leveraged buyout (LBO) is defined as a takeover of a company, financed by borrowed funds (often, the target
company’s assets are used as security for the loans acquired
to finance the purchase; the acquiring company or group
then repays the loans from the target company’s profits or
by selling its assets); leveraged buyouts occur at both the
corporate and divisional levels (sometimes only part of the
firm is sold off ); through these buyouts, the companies (or
divisions) are converted from publicly traded to closely held corporations.
limited liability refers to organizations (like corporations) in which the owners’ risk associated with the organization
is limited to their capital contributions.
limited liability company is a legal form of organization that is similar to an S corporation; it allows owners to
Glossary G-7
obtain the benefits of pass-through tax treatment and
limited liability.
limited liability partnership (LLP) is a legal form of organization available for partnerships consisting of groups
of certain types of professionals (such as attorneys, doctors,
and accountants); similar to general partnerships except that individual partners are shielded from certain vicarious
liabilities.
limited partnership is a partnership in which one or more “general” partners manage the business while “limited”
partners contribute capital and share in the profits but take
no part in running the business; general partners are
personally liable for the partnership’s debts, while limited
partners incur no liability with respect to partnership
obligations beyond their capital contributions.
logroll consists of a coalition of individuals who are largely indifferent to one another’s demands, but agree to support a
variety of requests so that each can get what he wants.
long run is the period of time over which the firm has complete flexibility; no inputs are fixed.
long-run cost curves—see planning curves.
M form organization—see multidivisional form. Malcolm Baldrige National Quality Award was instituted in 1987 by the U.S. government to recognize
quality achievement by American companies.
marginal analysis considers only the incremental costs and benefits in making a decision; costs and benefits that do not
vary with the decision are sunk and hence are irrelevant.
marginal benefits are the incremental benefits associated with making a decision.
marginal cost (MC) is the change in total costs associated with a one-unit change in output—marginal costs can be defined for either the long run or the short run.
marginal-cost transfer prices use marginal production cost to value goods exchanged between business units.
marginal product (MP) of an input is the change in total output associated with a one-unit change in the input,
holding other inputs fixed.
marginal revenue (MR) is the change in total revenue given a one-unit change in quantity.
marginal revenue product (MRP) is the incremental revenue that the firm obtains from employing one more unit of the input (the incremental output times the incremental
revenue)—also called the value of the marginal product.
market consists of all firms and individuals who are willing and able to buy or sell a particular product.
market-based transfer prices use external market prices to value goods exchanged between business units.
market-clearing price is the price at which the quantity supplied of a product is equal to the quantity demanded.
market failures occur because of externalities, public goods, monopolies, and information failures; they keep markets from then providing an efficient allocation of resources.
market for corporate control is a term used to describe how outsiders can obtain voting control in a publicly traded
company through the purchase of shares in the open
market; control transactions often are associated with
corporate takeovers and mergers.
market power occurs when a firm faces a downward- sloping demand curve; it can raise prices without losing all sales.
market structure refers to the basic characteristics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of
information about product price and quality; and (4) the conditions for entry and exit.
markup pricing sets price by estimating its price elasticity and marking up marginal costs; the firm substitutes these estimates into MC*�[1 � 1��*].
matrix organizations are those that are characterized by intersecting lines of authority; they have functional
departments (such as finance, manufacturing, and
development), but employees from these functional
departments also are assigned to subunits organized around
product, geography, or some special project—individuals
report to both a functional manager and a product manager.
See function and functional subunits.
meeting-the-competition clause is a contractual provision that guarantees that the seller will match the price offered
by a competitor.
menu plans—see cafeteria-style benefit plans.
menu pricing involves offering all potential customers the same menu of purchase options. Customers self-select
among the alternatives, thus revealing information about
their demand elasticities—also called second-degree price discrimination.
minimum efficient scale is the plant size at which long- run average cost first reaches its minimum.
monitoring rights represent the opportunity to oversee whether the obligations of another party have been met.
monopolistic competition is a market structure that is a hybrid between competitive markets and monopoly; firms have downward-sloping demand curves for their
G-8 Glossary
differentiated products, but economic profits are limited by entry and competition (examples include the markets for toothpaste and golf balls).
monopoly is a market structure where there is only one firm in the industry; here, industry and firm demand curves are the same.
moral-hazard problems—see postcontractual information problems.
most-favored-nation clause is a contractual provision that guarantees the seller will not sell to another buyer at a
lower price.
motion studies are the systematic analysis of work methods considering the use of raw materials, the design of
the product or process, the order of work, the tools, and the
activities at each step.
multicollinearity is a statistical problem that arises when the factors that affect a dependent variable in a regression
are highly correlated (tend to move together); it can make it
difficult to estimate the individual effects of the explanatory
variables with much precision.
multidivisional form of firm organization groups jobs into a collection of business units based on factors such as
product or geographic area; operating decisions such as
product offerings and pricing are decentralized to the
business unit; and each business unit has its own functional subunits—also called M form organization.
multitask principal-agent model examines the incentive problems that arise when an employee is assigned multiple
tasks.
Nash equilibrium occurs when each firm is doing the best it can, given the actions of its rivals.
negotiated transfer prices use prices set by negotiation between the two business units to value goods exchanged
between them.
network effects occur where the demand for a product increases with the number of users (for example, fax
machines are more useful the more people use them).
network organizations are those that are organized into work groups based on function, geography, or some other dimension; the relationships among these work groups are
determined by the demands of specific projects and work
activities, rather than by formal lines of authority; these
relationships are fluid and frequently change with changes
in the business environment.
nonprofit organization is a legal form of organization in which persons who control the organization are forbidden
from receiving the residual profits; these organizations
receive significant tax breaks; only organizations with a
social purpose can organize as nonprofits—see for-profit organizations.
normal goods are those for which the quantity purchased increases with income.
Objective performance measure is a measure that is easily observable and quantifiable.
oligopolistic market is a market structure that has only a few firms which account for most of the production in the market; products may or may not be differentiated; firms can earn economic profits.
omitted variables problem is a statistical problem that arises from estimating equations without all the relevant
explanatory variables.
operating cost curves are used in making near-term production and pricing decisions—also called short-run cost curves.
opportunity cost is the value of the resource in its next best alternative use.
organizational architecture comprises the three critical aspects of corporate organization: (1) the assignment of
decision rights within the company, (2) the methods of rewarding individuals, and (3) the structure of systems to
evaluate the performance of both individuals and business
units.
outside directors are commonly defined as board members who are not existing managers or their family members.
The stock exchanges have more stringent definitions of
outside or independent directors.
outsourcing is moving an activity outside the firm that formerly was done within the firm; it can also refer to an
outgoing arrangement for using external firms either to
supply inputs or distribute products.
Pareto efficiency occurs when there is no feasible alternative that keeps all individuals at least as well off but
makes at least one person better off.
passing-the-baton is a prominent model used by companies for top management succession. An heir
apparent to the CEO is identified and given a title such as
president or COO. Contingent on firm and individual
performance, the heir apparent eventually becomes the new
CEO.
pass-through organization is one in which the income of the organization is passed through to the owners’ tax
returns and is taxed only at the personal level.
Glossary G-9
performance evaluation is the process of appraising the correspondence between employee productivity and
employer expectations.
personalized pricing occurs when the producer extracts all potential consumer surplus from each potential consumer— also called first-degree price discrimination.
physical asset specificity—see asset specificity.
planning curves play a key role in longer-run planning decisions relating to plant size and equipment acquisition—
also called long-run cost curves.
postcontractual information problems are agency problems that occur because of asymmetric information after the contract is negotiated; individuals have incentives
to deviate from the contract and take self-interested actions
because the other party has insufficient information to
know whether the contract was honored—also called
moral-hazard problems.
potential entrants are all firms that pose a sufficiently credible threat of market entry to affect the pricing and output decisions of incumbent firms.
precontractual information problems are contracting problems that occur because of asymmetric information at the time the contract is being negotiated; these problems
include adverse selection and bargaining failures.
preferred stock is a type of stock whose holders are given priority of common stockholders in receiving dividends.
The dividend is typically fixed at the time of issue.
price discrimination occurs whenever a firm’s prices in different markets are not related to differentials in production and distribution costs; it involves charging
different consumers different prices based on their
elasticities of demand.
price elasticity of demand—see elasticity of demand.
principal-agent model examines incentive problems among contracting parties, especially within
organizations.
prisoners’ dilemma is a game-theory model that examines the tension between group interest and individual self-
interest; the equilibrium is for the two prisoners to confess, even though it is in their joint interest not to confess.
product attributes are the various characteristics of a product that buyers value.
product life cycle is the pattern in the demand for products over their life cycles; it is divided into four stages:
introduction, growth, maturity, and decline. Typically, the
demand for a successful product increases rapidly through
the growth phase; the demand tends to level off during the
maturity phase; it eventually drops when the product enters
the decline phase.
production function specifies the maximum feasible output that can be produced for given quantities of inputs.
profit centers are business units whose managers are given decision rights for input mix, product mix, and selling prices (or output quantities) and are asked to maximize
profits given a fixed capital budget.
profit-maximizing level of production occurs when marginal revenue equals marginal cost.
property right is an enforceable right to select the uses of a good.
proxy statement refers to a document, which the SEC requires a company to send to its shareholders, that provides
material facts concerning matters on which the shareholders
will vote.
Public Companies Accounting and Oversight Board (PCAOB) oversees public accountants’ audits of publicly traded corporations. Created by the Sarbanes-Oxley Act of
2002.
public goods are those commodities whose consumption by one person does not diminish the amount available to
others.
publicly traded corporations are characterized by stock that is sold to and traded among the general public (often
on organized exchanges, such as the New York Stock
Exchange).
Quality can refer to high mean, low variance, more options, or meeting customer expectations.
quality circles are voluntary work groups that meet regularly to discuss how to improve the quality of products and work processes.
R atchet effect refers to basing next year’s performance standard on this year’s actual performance; such standard
setting can induce employees to restrict production in the
current period in order to limit the increase in their future
performance benchmarks.
ratification rights are those that involve the choice of the business-decision initiatives to be implemented.
reaction curve displays one firm’s optimal choice (of output, for instance), given the choice of another firm.
reengineering is a management technique defined as the fundamental rethinking and radical redesign of business
processes to achieve improvements in measures of
performance, such as cost, quality, service, and speed.
relative-performance evaluation measures employees’ performance relative to peers.
G-10 Glossary
relative price is the price of one good as compared to another.
repeated relationship occurs when two parties expect to interact with each other over time; sometimes it is possible
for the parties to cooperate in a repeated relationship, even
though they would not cooperate in a one-time interaction
due to incentive conflicts.
reservation price is the maximum price that the buyer is willing to pay, or the minimum that the seller is willing to
accept.
reservation utility is the utility that the employee can obtain in the next best alternative; the employee must be
paid her reservation utility or she will not work for the firm.
residual claimants have the legal rights to the profits of the enterprise once the fixed claimants of the firm (for example, bondholders and employees) are paid.
residual income measures business-unit performance by subtracting a stated return on investment from division
profits.
residual loss is the dollar equivalent of the remaining loss in value that results because incentive problems have not
been completely resolved by out-of-pocket expenditures on
monitoring and bonding.
residual use rights for an asset are the rights to select any use that does not conflict with prior contract, custom, or law.
return on assets (ROA) is the ratio of accounting net income generated divided by total assets; ROA is a
commonly used investment-center performance measure.
returns to a factor define the relation between output and the variation in only one input, holding other inputs fixed.
returns to scale is the relation between output and a proportional variation of all inputs taken together.
revenue centers are business units that evaluate performance based on revenue generation.
risk-averse individuals prefer a lower level of risk, holding the expected payoff fixed.
risk-neutral individuals care only about expected value and are indifferent to the level of risk.
risk premium is the difference between the expected value of a risky income stream and its certainty equivalent.
S corporations were created in 1958 as part of a tax program to help small business; limits on the number
and type of shareholders make this organizational form
unattractive to most large firms; income is passed through
to the owners’ tax returns; shareholders have limited liability—see C corporations.
Sarbanes-Oxley Act of 2002 (SOX) is an important U.S. law relating to corporate governance and financial disclosure
adopted in the aftermath of the 2001–2002 corporate
governance scandals.
second-degree price discrimination—see menu pricing.
Securities and Exchange Commission (SEC) is the primary federal regulatory agency for the securities industry.
The SEC’s mandate is to promote full and accurate
disclosure and to protect investors against fraudulent and
manipulative practices in the securities markets.
self-selection occurs when people with differential private information identify themselves to outsiders by choosing
contracts that best fit with their private information.
shareholder proposals are voting proposals that are initiated by shareholders and often not supported by
management. They are included in the proxy statements
sent to shareholders. In the United States, boards of
directors do not have to adopt shareholder proposals even if
they receive a majority of affirmative votes.
short run is the operating period during which at least one input (frequently capital) is fixed in supply.
short-run cost curves—see operating cost curves.
short-run profit maximization occurs when marginal revenue equals short-run marginal cost.
shortage occurs when the price in the market is lower than the market-clearing price and quantity demanded is greater than quantity supplied; as inventories are depleted,
suppliers have incentives to raise prices.
shut-down condition in the short run occurs when price is lower than average variable cost; in the long run it occurs when price is lower than long-run average cost.
site specificity occurs when an asset is located in a particular place that makes it useful only to a small number
of buyers or suppliers and it cannot be moved easily—see
also asset specificity.
specialized task assignments are those in which individual employees concentrate on a limited set of tasks—see broad task assignment.
specific assets are those that are worth more in their current use than in alternative uses.
specific human capital is created by learning things that are expected to be useful only within a specific contractual
relationship—see asset specificity.
specific knowledge is that which is relatively expensive to transfer.
spot market is one in which the exchange is made immediately at the current market price with no long-term
commitment between the buyer and the seller.
Glossary G-11
stakeholders describe various parties affected by a corporation’s actions, such as shareholders, employees, and
the broader community.
standard rating scales require the performance evaluator to rank the employee on a number of different performance
factors using a scale (for example, far exceeds requirements,
exceeds requirements, meets all requirements, partially meets
requirements, does not meet requirements).
strategic alliances are any of a variety of agreements between independent firms to cooperate in the development and/or marketing of products.
strategy refers to the general policies that managers adopt to generate profits; rather than focus on operation detail,
a firm’s strategy addresses broad, long-term issues facing
the firm.
subjective performance evaluation is an evaluation that is based on the personal opinion of the supervisor rather than
on some objective measure (such as the quantity of output).
substitutes are goods that compete with each other; if the price of one good is increased, the consumer will tend to
shift purchases to the other good.
substitution effect in producing a product occurs when the firm shifts among inputs due to changes in their relative prices.
sunk costs are those nonrecoverable costs that have already been incurred and the resources have no alternative use.
supply curve displays the quantity producers are willing to sell at each price; the curve typically slopes upward—at
higher prices producers are able and willing to produce and
sell more units.
surplus occurs when the price in the market is higher than the market-clearing price and quantity supplied is greater than quantity demanded; as inventories build, suppliers
have incentives to reduce prices.
survival of the fittest is a principle implied by the concept of economic Darwinism; companies have the greatest chance of survival if they are organized efficiently given
their particular environment.
Team production occurs when interdependencies among employees and assets cause the value of the inputs
as a team to be greater than their opportunity costs.
telecommuting occurs when employees work out of their homes and communicate with the central office via fax,
computer, or telephone.
third-degree price discrimination—see group pricing.
three legs of the stool is an analogy used to characterize organizational architecture; like a balanced stool, a
well-designed organization should have an architecture in
which the three components (the assignment of decision rights, the reward system, and the performance-evaluation system) are coordinated.
time studies are a wide variety of techniques employed for determining the duration a particular activity requires under
certain standard conditions.
total cost curve (TC) displays the relation between total costs (total fixed costs plus total variable costs) and output.
total product (TP) of an input is the schedule of output obtained as the input increases, holding other inputs fixed.
total quality management (TQM) includes those management processes and organizational changes
necessary to meet customer expectations and to achieve
continual improvement.
total revenue is the product of price times quantity sold.
transaction costs—see contracting costs (note that this term frequently is used to refer only to out-of-pocket
contracting costs).
transfer price is the amount one business unit pays another for goods and services that are exchanged between them.
two-part tariff is a pricing mechanism in which the customer pays an up-front fee for the right to buy the
product and then pays additional fees for each unit of the
product consumed; two-part pricing is sometimes used in
contracts between manufacturers and distributors.
two-tier board is a board structure used in countries following the German model. The supervisory board
consists of large shareholders (including banks,
corporations, and insurance companies) and employee
representatives. Employee representatives have 50
percent of the board seats. The supervisory board selects
a management board that has primary operational
authority.
U form organization—see unitary organization. unitary elasticity of demand occurs when the price elasticity is equal to one; a small increase in price is associated with no change in total revenue.
unitary organization groups jobs by function (engineering, design, sales, finance, and so on); it places
each primary function in one major subunit (rather than in
multiple subunits)—also called U form organization.
unlimited liability refers to organizations (like general partnerships) in which the owners face unlimited personal liability for debt and other claims against the
organization.
G-12 Glossary
upstream integration—see backward integration.
utility is an index of personal well-being.
utility function is the relation between an individual’s well-being (utility) and the level of goods consumed.
Value of the marginal product (VMP)—see marginal revenue product.
variable costs are costs which change with the level of output.
vertical chain of production is the series of steps in the production process.
vertically integrated firms are those which participate in more than one successive stage in the vertical chain of production.
vision refers to a course of action for the firm—see also corporate strategy.
Work sampling is one type of time study that involves selecting a large number of observations taken at
random intervals and observing how long employees take
in performing various components of the job.
- Front Cover
- Title Page
- Copyright Page
- Dedication Page
- Preface
- Contents in Brief
- CONTENTS
- Part 1 Basic Concepts
- Part 2 Managerial Economics
- Part 3 Designing Organizational Architecture
- Part 4 Applications of Organizational Architecture
- PART 1 Basic Concepts
- 1. Introduction
- Outline & Objectives
- Managerial Economics and Organizational Architecture
- Organizational Architecture
- Economic Analysis
- Economic Darwinism
- Survival of the Fittest
- Economic Darwinism and Benchmarking
- Purpose of the Book
- Our Approach to Organizations
- 2. Economists' View of Behavior
- Outline & Objectives
- Economic Behavior: An Overview
- Economic Choice
- Marginal Analysis
- Opportunity Costs
- Creativity of Individuals
- Graphical Tools
- Individual Objectives
- Indifference Curves
- Opportunities and Constraints
- Individual Choice
- Changes in Choice
- Motivating Honesty at Merrill Lynch
- Managerial Implications
- Alternative Models of Behavior
- Only-Money-Matters Model
- Happy-Is-Productive Model
- Good-Citizen Model
- Product-of-the-Environment Model
- Which Model Should Managers Use?
- Behavioral Economics
- Decision Making under Uncertainty
- Expected Value
- Variability
- Risk Aversion
- Certainly Equivalent and Risk Premium
- Risk Aversion and Compensation
- Summary
- Appendix A: Consumer Choice
- Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem
- 3. Exchange and Markets
- Outline & Objectives
- Goals of Economic Systems
- Property Rights and Exchange in a Market Economy
- Dimensions of Property Rights
- Gains from Trade
- Basics of Supply and Demand
- The Price Mechanism
- Shifts in Curves versus Movements along Curves
- Using Supply and Demand Analysis for Qualitative Forecasts
- Linear Supply and Demand
- Supply and Demand—Extended Analysis
- Price versus Quantity Adjustments
- Short-Run versus Long-Run Effects
- Industry Cost Increases and Price Adjustments
- Prices as Social Coordinators
- Efficient Exchange and Production
- Measuring the Gains from Trade
- Government Intervention
- Externalities and the Coase Theorem
- Markets versus Central Planning
- General versus Specific Knowledge
- Knowledge Creation
- Specific Knowledge and the Economic System
- Incentives in Markets
- Contracting Costs and Existence of Firms
- Contracting Costs in Markets
- Contracting Costs within Firms
- Managerial Decisions
- Summary
- Appendix: Shareholder Value and Market Efficiency
- PART 2 Managerial Economics
- 4. Demand
- Outline & Objectives
- Demand Functions
- Demand Curves
- Law of Demand
- Elasticity of Demand
- Linear Demand Curves
- Other Factors That Influence Demand
- Prices of Related Products
- Income
- Other Variables
- Industry versus Firm Demand
- Network Effects
- Product Attributes
- Product Life Cycles
- Demand Estimation
- Interviews
- Price Experimentation
- Statistical Analysis
- Implications
- Summary
- Appendix: Demand
- 5. Production and Cost
- Outline & Objectives
- Production Functions
- Returns to Scale
- Returns to a Factor
- Choice of Inputs
- Production Isoquants
- Isocost Lines
- Cost Minimization
- Changes in Input Prices
- Costs
- Cost Curves
- Short Run versus Long Run
- Minimum Efficient Scale
- Learning Curves
- Economies of Scope
- Profit Maximization
- Factor Demand Curves
- Cost Estimation
- Summary
- Appendix: The Factor-Balance Equation
- 6. Market Structure
- Outline & Objectives
- Markets
- Competitive Markets
- Firm Supply
- Competitive Equilibrium
- Barriers to Entry
- Incumbent Reactions
- Incumbent Advantages
- Exit Costs
- Monopoly
- Monopolistic Competition
- Oligopoly
- Nash Equilibrium
- Output Competition
- Price Competition
- Empirical Evidence
- Cooperation and the Prisoners' Dilemma
- Summary
- 7. Pricing with Market Power
- Outline & Objectives
- Pricing Objective
- Benchmark Case: Single Price per Unit
- Profit Maximization
- Estimating the Profit-Maximizing Price
- Potential for Higher Profits
- Homogeneous Consumer Demands
- Block Pricing
- Two-Part Tariffs
- Price Discrimination—Heterogeneous Consumer Demands
- Exploiting Information about Individual Demands
- Using Information about the Distribution of Demands
- Bundling
- Other Concerns
- Multiperiod Considerations
- Strategic Interaction
- Legal Issues
- Implementing a Pricing Strategy
- Summary
- 8. Economics of Strategy: Creating and Capturing Value
- Outline & Objectives
- Strategy
- Value Creation
- Production and Producer Transaction Costs
- Consumer Transaction Costs
- Other Ways to Increase Demand
- New Products and Services
- Cooperating to Increase Value
- Converting Organizational Knowledge into Value
- Opportunities to Create Value
- Capturing Value
- Market Power
- Superior Factors of Production
- A Partial Explanation for Walmart's Success
- All Good Things Must End
- Economics of Diversification
- Benefits of Diversification
- Costs of Diversification
- Management Implications
- Strategy Formulation
- Understanding Resources and Capabilities
- Understanding the Environment
- Combining Environmental and Internal Analyses
- Strategy and Organizational Architecture
- Can All Firms Capture Value?
- Summary
- 9. Economics of Strategy: Game Theory
- Outline & Objectives
- Game Theory
- Simultaneous-Move, Nonrepeated Interaction
- Analyzing the Payoffs
- Dominant Strategies
- Nash Equilibrium Revisited
- Competition versus Coordination
- Mixed Strategies
- Managerial Implications
- Sequential Interactions
- First-Mover Advantage
- Strategic Moves
- Managerial Implications
- Repeated Strategic Interaction
- Strategic Interaction and Organizational Architecture
- Summary
- Appendix: Repeated Interaction and the Teammates' Dilemma
- 10. Incentive Conflicts and Contracts
- Outline & Objectives
- Firms
- Incentive Conflicts within Firms
- Owner-Manager Conflicts
- Other Conflicts
- Controlling Incentive Problems through Contracts
- Costless Contracting
- Costly Contracting and Asymmetric Information
- Postcontractual Information Problems
- Precontractual Information Problems
- Implicit Contracts and Reputational Concerns
- Incentives to Economize on Contracting Costs
- Summary
- PART 3 Designing Organizational Architecture
- 11. Organizational Architecture
- Outline & Objectives
- The Fundamental Problem
- Architecture of Markets
- Architecture within Firms
- Architectural Determinants
- Changing Architecture
- Interdependencies and Complementarities within the Organization
- Corporate Culture
- When Management Chooses an Inappropriate Architecture
- Managerial Implications
- Evaluating Management Advice
- Benchmarking
- Summary
- 12. Decision Rights: The Level of Empowerment
- Outline & Objectives
- Assigning Tasks and Decision Rights
- Centralization versus Decentralization
- Benefits of Decentralization
- Costs of Decentralization
- Illustrating the Trade-offs
- Management Implications
- Lateral Decision-Right Assignment
- Assigning Decision Rights to Teams
- Benefits of Team Decision Making
- Costs of Team Decision Making
- Management Implications
- Decision Management and Control
- Decision-Right Assignment and Knowledge Creation
- Influence Costs
- Summary
- Appendix: Collective Decision Making
- 13. Decision Rights: Bundling Tasks into Jobs and Subunits
- Outline & Objectives
- Bundling Tasks into Jobs
- Specialized versus Broad Task Assignment
- Productive Bundling of Tasks
- Bundling of Jobs into Subunits
- Grouping Jobs by Function
- Grouping Jobs by Product or Geography
- Trade-offs between Functional and Product or Geographic Subunits
- Environment, Strategy, and Architecture
- Matrix Organizations
- Mixed Designs
- Network Organizations
- Organizing within Subunits
- Recent Trends in Assignments of Decision Rights
- Summary
- Appendix: Battle of the Functional Managers
- 14. Attracting and Retaining Qualified Employees
- Outline & Objectives
- Contracting Objectives
- The Level of Pay
- The Basic Competitive Model
- Human Capital
- Compensating Differentials
- Costly Information about Market Wage Rates
- Internal Labor Markets
- Reasons for Long-Term Employment Relationships
- Costs of Internal Labor Markets
- Pay in Internal Labor Markets
- Careers and Lifetime Pay
- Influence Costs
- The Salary–Fringe Benefit Mix
- Employee Preferences
- Employer Considerations
- The Salary–Fringe Benefit Choice
- Summary
- 15. Incentive Compensation
- Outline & Objectives
- The Basic Incentive Problem
- Incentives from Ownership
- Optimal Risk Sharing
- Effective Incentive Contracts
- Principal-Agent Model
- Informativeness Principle
- Group Incentive Pay
- Multitasking
- Forms of Incentive Pay
- Incentive Compensation and Information Revelation
- Selection Effects of Incentive Contracts
- Does Incentive Pay Work?
- Summary
- Appendix: Multitasking Theory
- 16. Individual Performance Evaluation
- Outline & Objectives
- Setting Performance Benchmarks
- Time and Motion Studies
- Past Performance and the Ratchet Effect
- Measurement Costs
- Opportunism
- Gaming
- Horizon Problem
- Relative Performance Evaluation
- Within-Firm Performance
- Across-Firm Performance
- Subjective Performance Evaluation
- Multitasking and Unbalanced Effort
- Subjective Evaluation Methods
- Problems with Subjective Performance Evaluations
- Combining Objective and Subjective Performance Measures
- Team Performance
- Team Production
- Evaluating Teams
- Government Regulation of Labor Markets
- Summary
- Appendix: Optimal Weights in a Relative Performance Contract
- 17. Divisional Performance Evaluation
- Outline & Objectives
- Measuring Divisional Performance
- Cost Centers
- Expense Centers
- Revenue Centers
- Profit Centers
- Investment Centers
- Transfer Pricing
- Economics of Transfer Pricing
- Common Transfer-Pricing Methods
- Reorganization: The Solution If All Else Fails
- Internal Accounting System and Performance Evaluation
- Uses of the Accounting System
- Trade-offs between Decision Management and Decision Control
- Summary
- Capstone Case Study on Organizational Architecture: Arthur Andersen LLP
- PART 4 Applications of Organizational Architecture
- 18. Corporate Governance
- Outline & Objectives
- Publicly Traded Corporations
- Corporate Form of Organization
- Stock Exchanges
- Stock Ownership Patterns
- Governance Objectives
- Separation of Ownership and Control
- Incentive Issues
- Survival of Corporations
- Benefits of Publicly Traded Corporations
- Top-Level Architecture in U.S. Corporations
- Sources of Decision Rights
- Shareholders
- Board of Directors
- Top Management
- External Monitors
- International Corporate Governance
- Market Forces
- Sarbanes-Oxley Act of 2002
- Corporate Governance: An Historical Perspective
- Summary
- Web Appendix: Choosing among the Legal Forms of Organization
- 19. Vertical Integration and Outsourcing
- Outline & Objectives
- Vertical Chain of Production
- Benefits of Buying in Competitive Markets
- Reasons for Nonmarket Transactions
- Contracting Costs
- Market Power
- Taxes and Regulation
- Other Considerations
- Vertical Integration versus Long-Term Contracts
- Incomplete Contracting
- Ownership and Investment Incentives
- Specific Assets and Vertical Integration
- Asset Ownership
- Other Reasons
- Continuum of Choice
- Contract Duration
- Contracting with Distributors
- Free-Rider Problems
- Double Markups
- Regulatory Issues
- Trends in Outsourcing
- Summary
- Appendix: Ownership Rights and Investment Incentives
- 20. Leadership: Motivating Change within Organizations (WEB)
- Outline & Objectives
- Leadership
- Vision Setting
- Motivation
- Decision Making within Firms
- Incentive Problems and Organizational Politics
- Understanding Attitudes toward Change
- Changing Organizational Architecture
- Proposal Design
- Maintaining Flexibility
- Commitment
- Distributional Consequences
- Marketing a Proposal
- Careful Analysis and Groundwork
- Relying on Reputation
- Emphasizing a Crisis
- Organizational Power
- Sources of Power
- Tying the Proposal to Another Initiative
- Coalitions and Logrolling
- Is Organizational Power Bad?
- The Use of Symbols
- Summary
- Appendix: Strategic Value of Commitment and Crisis
- 21. Understanding the Business Environment: The Economics of Regulation
- Outline & Objectives
- Importance of Regulation to Managers
- Economic Motives for Government Intervention
- Defining and Enforcing Property Rights
- Redressing Market Failures
- Redistributing Wealth
- Economic Theory of Regulation
- Demand for Regulation: Special Interests
- Supply of Regulation: Politicians
- Market for Regulation
- Deadweight Losses, Transaction Costs, and Wealth Transfers
- Managerial Implications
- Restricting Entry and Limiting Substitutes
- Forming Coalitions
- On Business Participation in the Political Process
- Summary
- 22. Ethics and Organizational Architecture
- Outline & Objectives
- Ethics and Choices
- Corporate Mission: Ethics and Policy Setting
- Ethics
- Value Maximization
- Corporate Social Responsibility
- Economists' View of Social Responsibility
- Corporate Policy Setting
- Mechanisms for Encouraging Ethical Behavior
- Contracting Costs: Ethics and Policy Implementation
- Codes of Ethics
- Altering Preferences
- Education
- Corporate Culture
- Summary
- 23. Organizational Architecture and the Process of Management Innovation (WEB)
- Outline & Objectives
- Management Innovations
- The Demand for Management Innovations
- The Rise of TQM
- Other Innovations
- Why Management Innovations Often Fail
- Marketing
- Underestimating Costs of Change
- Failure to Consider Other Legs of the Stool
- Managing Changes in Organizational Architecture
- Summary
- INDEX
- A
- B
- C
- D
- E
- F
- G
- H, I
- J
- K, L
- M
- N
- O
- P
- Q
- R
- S
- T
- U
- V, W
- X, Y, Z
- Glossary (WEB)
- A, B
- C
- D
- E, F
- G
- H
- I
- J, K, L
- M
- N
- O
- P
- Q, R
- S
- T, U
- V, W
