EC 500

Chapter 6The Organization of the Firm

And Related Issues

OverviewI. Methods of Procuring Inputs (Skip)

Spot Exchange Contracts Vertical Integration

II. Transaction Costs (Skip) Specialized Investments

III. Optimal Procurement Input (Skip)

IV. Principal-Agent Problem Owners-Managers Managers-Workers Related Economic Issues and Terms

The Principal-Agent Problem• Occurs when the principal cannot observe the effort of

the agent. Example: Shareholders (principal) cannot observe the effort of the

manager (agent). Example: Manager (principal) cannot observe the effort of workers

(agents).

• The principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent.

• Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, the agent posting a bond, or fear of firing.

• The Problem: Principal cannot determine whether a bad outcome was the result of the agent’s low effort or due to bad luck.

Manager’s must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with that of the firm.

Shareholders must create plans to align the interest of the manager with those of the shareholders.

How can we resolve?

• The principal-agent problem arises when all contracts are written in a world of information asymmetry, uncertainty and risk. Here, principals do not know enough about whether (or to what extent) a contract has been satisfied.

• The solution to this information problem is to ensure the provision of appropriate incentives so agents act in the way principals wish.

• In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires.

Solving the Problem Between Owners and Managers

• Internal incentives Incentive contracts. Stock options, year-end bonuses.

• External incentives Personal reputation. Potential for takeover.

Solving the Problem Between Managers and Workers

• Profit sharing

• Revenue sharing

• Piece rates

• Time clocks and spot checks

Moral Hazard Problem

• Moral hazard refers to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behavior.

• Moral hazard refers to any situation where a person or organization does not bear the full adverse consequences of its actions.

Examples of Moral Hazard

• Lending and Debt Rescue operations carried out by governments, central

banks, or consortiums of financial institutions can encourage risky lending, if lenders know that in case of serious problems they will not have to take losses. Similarly, if governments know that inability to pay creditors will lead to yet more loans (to prop up finances), then they are less likely to have sound financial policies.

• Insurance Increased risk of problematic (immoral) behavior, and

thus a negative outcome ("hazard"), because the person who caused the problem doesn't suffer the full (or any) consequences, or may actually benefit.

Example: Fire insurance increases the incentive to commit arson, especially if someone is operating a failing business and decides that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves.

Adverse selection

• Adverse selection refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected.

• A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers.

• Adverse selection describes a situation where, as a result of private information, the insured are more likely to suffer a loss than the uninsured.

• For example, suppose that there are two groups among the population, smokers and non-smokers. An insurer selling life policies can't tell which is which, so they each pay the same premiums. Non-smokers are likely to die older than average, while smokers are likely to die younger than average. So the life policy is a better buy for the smokers' beneficiaries. So market failure is involved.

• Adverse selection in Trade can be a problem when there is asymmetric information between the seller and the buyer; in particular, a trade will often produce an asymmetric premium for buyer or seller, if one trader has better/more complete information (e.g., about what other traders are doing, the complete trading book for a stock, etc.) than the average.

• Do Relaters perform better?

The market for lemons

• For example, George Akerlof developed the model of the "market for lemons." People buying used cars do not know whether they are "lemons" (bad cars) or "cherries" (good ones), so they will be willing to pay a price that lies in between the price for lemons and cherries, a willingness based on the probability that a given car is a lemon or cherry.

• For instance, if the probability of getting either a lemon or a cherry is 0.5, and the price for a lemon and a cherry is $5,000 and $10,000 respectively, the price they are willing to pay for a used car would be 0.5(5,000) + 0.5(10,000) = $7,500.

Rent seeking

• Rent seeking occurs when an individual, organization, or firm seeks to make money by manipulating the economic environment rather than by making a profit through trade and production of wealth.

• The term comes from the notion of economic rent, but in modern use of the term, rent-seeking is more often associated with government regulation than with land rents.

• Rent seeking generally implies the extraction of uncompensated value from others without making any contribution to productivity, such as by gaining control of land and other pre-existing natural resources, or by imposing burdensome regulations or other government decisions that may affect consumers or businesses.

• While there may be few people in modern industrialized countries who do not gain something, directly or indirectly, through some form or another of rent seeking, rent seeking in the aggregate may impose substantial losses on society.

• Most studies of rent seeking focus on efforts to capture special monopoly privileges, such as government regulation of free enterprise competition, though the term itself is derived from the far older and more established practice of appropriating a portion of production by gaining ownership or control of land.

• Often-cited examples include a farm lobby that seeks tariff protection or an entertainment lobby that seeks expansion of the scope of copyright.

• Other rent seeking is held to be associated with efforts to cause a redistribution of wealth by, for example, shifting the government tax burden or government spending allocation.

Free Rider Problem

• Free riders are actors who consume more than their fair share of a resource, or shoulder less than a fair share of the costs of its production.

• free riding is usually only considered to be an economic "problem" when it leads to the non-production or under-production of a public good, and thus to Pareto inefficiency, or when it leads to the excessive use of a common property resource.

• In the labor union context, a free rider is an employee who pays no union dues or agency shop fees, but nonetheless receives the same benefits of union representation as dues-payers.

• Free riding is also a term used by brokerages when a client purchases shares beyond his or her means. In other words free riders are those that purchase shares that do not pay for them. The brokerage also places these trades in "good faith" a trade to be placed when funds are not available in the account

Malibu surfer problem

• Malibu surfer problem is the prospect of an individual who can work but chooses not to do so, and instead leads a life of self-indulgence funded through some other available means of support. The phrase refers to an imagined resident of Malibu, California who chooses to surf rather than work.

• Persons of considerable personal wealth (especially those who inherited their fortunes rather than earning it) can live off the money produced by their investments without having to do any actual work.

• In modern welfare systems, which hand out money and other benefits to unemployed persons.

Conclusion

• To overcome the principal-agent problem, principals must devise plans to align the agents’ interests with the principals.

Homework

• Find ONE practical example of each of the following issues.

Principal-Agent Problem Moral Hazard Problem Adverse selection Problem Rent seeking problem Problem of the market for lemons Free Rider Problem Malibu surfer problem

• Textbook, Chapter 6, Q.11, 15, 16, p. 230-231.