incentive conflicts and contracts

Managerial Economics and Organizational Architecture, Chapter 10

Incentive Conflicts and Contracts


Incentive Conflicts and Contractslearning objectives

Students should be able to

• Describe and offer examples of several kinds of incentive conflicts in firms

• State the role of contracts in reducing incentive conflicts

• Describe and offer examples of several pre- and postcontractual information problems


Examples of incentive conflicts

• Owner versus manager– profits or salaries and perks– work hard or shirk– take chances or play it safe

• Buyer versus supplier

• Free ride or not

• Management versus labor


The role of contracts

• Costless contracting– ideal contracts would align interests (minimize

incentive conflicts) at no or low cost

• Costly contracting and asymmetric information– contracts costly to negotiate, write, administer– parties to contract have asymmetric information

on performance levels


Firm as focal point for set of contracts


Postcontractual information problems

• Agency problems– principal contracts with agent for service– agent has postcontractual incentive to serve

own perceived best interests

• Asymmetric information complicates resolution of agency problems– principal incurs monitoring costs and/or– agent incurs bonding costs


Optimal combination of compensation and perks

CEO utility function, C is compensation, P is perquisites: U=f(C,P)

Owners have precise knowledge of profit potential: p

Realized profits are: R=p-P

Therefore offer CEO compensation contract:

C=S-(p- R)


Optimal perquisite taking


Postcontractual information problems

• Agency problems– principal contracts with agent for service– agent has postcontractual incentive to serve

own perceived best interests

• Incentives to economize on agency costs– sharing increased gains from trade


Agency Cost ExampleGood Tire Company and Brown & Brown

• Good Tire’s marginal benefit from legal services: MB=200-2L

• Brown & Brown’s marginal cost for providing legal services: MC=100

• Value maximization: MB=MC, or

200-2L=100, L*=50

• Fee of $6250 covers costs of $5000 and yields net benefits of $1250 each


Agency Cost ExampleGood Tire Company and Brown & Brown

• BUT Brown & Brown may have incentive to provide fewer than 50 hours

• Costly for Good Tire to monitor or for B&B to provide guarantee

• Possible outcome is reduced gain from trade (foregone surplus)


Agency costs in legal contracting


Precontractual information problems

• Bargaining failures– asymmetric information

• Adverse selection– use of private information in manner

detrimental to trading partner


Implicit contracts and reputations

• Implicit contracts -- agreements and understandings that can’t be legally enforced

• Reputational concerns can motivate implicit contract compliance

incentive conflicts and contracts

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