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Contracting, Governance and Organizational Form Chapter # 15 • Coordination and control are problems Contracting, Governance and Organizational Form Chapter # 15 • Coordination and control are problems for all business organizations. The larger the organization, the larger the problem. • Contracts help insure performance, but most contracts are incomplete, and thus can be thwarted through moral hazard. • Goods are allocated in free markets by using prices. • However, there alternative allocative mechanisms that are adopted, such as vertical mergers to avoid using prices. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Slide 1

Role of Business Contracting in Cooperative Games • The amount of advertising and service Role of Business Contracting in Cooperative Games • The amount of advertising and service can be viewed as a game. • The outcome can be sub-optimal; that is, it is not value maximizing. The cooperative solution sometime yields better payoffs. • To get to a value-maximizing solution, the manufacturer may have to consider side payments or credible commitments to the retailer. Slide 2

Figure 15. 1 Vertical Requirements Contracting • • A manufacturer (M) can update its Figure 15. 1 Vertical Requirements Contracting • • A manufacturer (M) can update its product or not update it. The retail ( R) can continue selling efforts or not If M updates, R discontinues efforts, but best is for M to advertise anyway and get $280, 000 and R $120, 000. If R continues efforts, R will end up with just $100, 00. How do we get the maximum payoff for both $480, 000, Retail Manufacturer when each has an incentive to shirk? Advertise $180, 000 $300, 000 Continue Not selling efforts M 1 Advertise $100, 000 $350, 000 Update M Not Update Advertise $120, 000 $280, 000** R 1 Discontinue selling efforts Continue selling efforts R 2 Discontinue selling efforts M 2 M 3 M 4 Not Advertise $ 40, 000 $120, 000 Not Advertise $60, 000 $380, 000 Not Advertise $130, 000 $150, 000 Slide 3

Contracts • Contracts between players are binding, they specify actions by both parties. » Contracts • Contracts between players are binding, they specify actions by both parties. » A contract is a third party enforceable agreement to facilitate deferred exchange. • Contracts must assign penalties for not living up to the agreement. These payments are part of a several step sequential game. » If the retailer decides to discontinue a service for a product the manufacturer produces, then the contract can provide economic sanctions that make this decision unattractive. Slide 4

Vertical Requirements Contract • A vertical requirements contract is one in which the firms Vertical Requirements Contract • A vertical requirements contract is one in which the firms in successive stages of production agree to payments and/or penalties for taking an action. • Contracts must assign penalties for not living up to the agreement. These payments are part of a several step sequential game. » If the manufacturer spends a large amount to advertise the product, the distributor promises to promote the product as well. • Expectation damages are remedies for breach of contract designed to elicit efficient precaution and efficient reliance on promises. These are payments for non-performance of a contract. Slide 5

Frustration of Purpose Doctrine • Suppose you enter into an agreement to sell a Frustration of Purpose Doctrine • Suppose you enter into an agreement to sell a truck that uses 100% ethanol. • But suppose the government changes rules making ethanol use prohibited. • The Uniform Commercial Code (UCC) provided the frustration of purpose doctrine to excuse the truck manufacturer from delivering something it is prohibited in doing. This would likely give the truck manufacturer a way to avoid ‘expectation damages’ if sued by the truck retailer. Slide 6

A Spectrum of Contract Environments • Spot Market Transaction – one time only exchange A Spectrum of Contract Environments • Spot Market Transaction – one time only exchange of standardized goods » Tends to be between anonymous buyers and sellers, and information tends to be efficient » The purchase of a dozen ears of corn at a roadside stand or the sale of electricity at a spot rate off the grid, are examples of spot markets. • Vertical Requirements Contracts – promise of future performance for immediate consideration » Tends to be between contract partners that know each other, but there are problems with ambiguity • Relational Contract – between repeat business parties » Tends to be self-enforcing because we can see if the other partner lives up to his or her word. Slide 7

Incomplete Information and Incomplete Contracting • Incomplete Information -- uncertain knowledge of payoffs, choices, Incomplete Information and Incomplete Contracting • Incomplete Information -- uncertain knowledge of payoffs, choices, or types of opponents a market player faces. • Insurance works when we can pool a group of possible events (like injuries at work) to reduce the risk of loss to any one party. • But some risks are catastrophic, like a nuclear accident. It is difficult to assess the likelihood or the damage; hence, insurance in this case is often unavailable. • Contracts can specify duties under several states of the world, but sometimes the outcomes are too numerous or unknowable for years. This creates incomplete contracts. Slide 8

Types • Full contingent claims contract -- specifies all possible future events. • Incomplete Types • Full contingent claims contract -- specifies all possible future events. • Incomplete contingent claims contract -- not all possible future events are specified. • Due to incomplete contracts, some people may take advantage of spirit of the contract. 4 Accident insurance may permit people to succumb to a moral hazard by acting recklessly. Slide 9

Corporate Governance and the Problem of Moral Hazard • Doing business in markets involves Corporate Governance and the Problem of Moral Hazard • Doing business in markets involves the cost of contracts. • When only incomplete contracts are possible, it is often the best to integrate the operations within a firm. • The moral hazard problem occurs when parties change their behavior due to contracts. This is especially true when the people’s effort is hard to observe. • In a borrower-lender contract, a reliable borrower, once given money in a loan, may elect to invest in highly risky projects. » To try to avoid this moral hazard, the bank may insist on costly monitoring or governance actions, forcing the borrower to submit frequent financial data. Slide 10

Implementaion of Mechanisms of Corporate Governance Table 15. 2 • Internal monitoring by an Implementaion of Mechanisms of Corporate Governance Table 15. 2 • Internal monitoring by an independent board of director subcommittee • Internal/external monitoring by large creditors • Internal/external monitoring by owners of large blocks of stock • Auditing and variance analysis • Internal benchmarking • Corporate culture of ethical duties • High employee morale supportive of whistle blowers Slide 11

The Principal-Agent Model • The agents (managers) may wish to maximize leisure and minimize The Principal-Agent Model • The agents (managers) may wish to maximize leisure and minimize risk, whereas the principal (shareholders) may wish hard work and high risk-return investments. • Example: an employee knows that working hard helps the whole firm, and helps himself only a little. Why not let the other workers be grinds and take it easy (be a free rider)? • Principal-Agent problems may lead to: • Risk Avoidance in Managers • Managers have Short Time Horizons • Sales Maximization • High Levels of Social Amenities at the Work Site • Satisficing or Sufficing Behavior Slide 12

Alternative Managerial Labor Contracts Figure 15. 3 • A consultant is hired for 50 Alternative Managerial Labor Contracts Figure 15. 3 • A consultant is hired for 50 hours at Wa. • Alternatively, a manager is paid a profit-sharing payment, ray AB, which is 40% of the profits » The first 22 hours, the consultant is overcompensated area AJD » The last 28 hours, consultant is under-compensated area DCF Wa » If Area O = Area U, the consultant is indifferent between fixed wage Wa and the 40% profit sharing deal • If profit sharing were reduced, to IB, then the consultant would prefer the fixed wage rate. $ E A I J O C D U F 10 22 SL DL B 50 Slide 13

Work Effort, Creative Ingenuity, and the Moral Hazard Problem • Profit sharing, in the Work Effort, Creative Ingenuity, and the Moral Hazard Problem • Profit sharing, in the previous example, has a problem. • After the first 22 hours, if the work is not observed, the consultant can earn Wa, at other work. • It is disloyal, but rational not to work has hard as possible for this employer. • The shirking consultant works for two employers. • With this outcome expected by the employer, the employer decides against offering a profit-sharing contract, and if possible, attempts to monitor the consultant by a piece rate. Slide 14

Principal-Agent Problem in Managerial Labor Markets • Stockholders (principals) hire managers (agents) with different Principal-Agent Problem in Managerial Labor Markets • Stockholders (principals) hire managers (agents) with different incentives. • Alternative labor contracts 3 Pay based on profits 3 Paying a bonus on top of a salary when goals are exceeded 3 Have manager own stock • Benchmarking involves a comparison of similar firms, plants, or divisions Slide 15

Signaling and Sorting of Managerial Talent n Applicants to positions know more about themselves Signaling and Sorting of Managerial Talent n Applicants to positions know more about themselves than they reveal, which is the problem of asymmetric information. Asymmetric Information -- unequal or dissimilar knowledge among market participants. n For example, is the applicant highly risk averse or a risk taker? Ø If I ask you if you are highly risk averse, you will likely tell me what I want to hear. n How can we sort between risk-takers and risk averse candidates? Slide 16

Screening and Sorting of Managerial Talent with Optimal Incentives Contracts • A Linear Incentive Screening and Sorting of Managerial Talent with Optimal Incentives Contracts • A Linear Incentive Contract is a combination of salary and (plus or minus!) a profit sharing rate. • A Pooling Equilibrium is an offer that dominates all other offers will not help distinguish among applicants. • A Separating equilibrium is an offers that distinguishes between behaviors • For example, a risk averse person would tend to select an offer which primarily paid a base salary • Whereas the risk-loving individual would tend to select an offer with more profit sharing. Slide 17

Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary B A Figure 15. 4 • Contract A has lower profit sharing rate and lower base rate than Indifference curve for the Contract B risk lover • Both a risk averse person and a risk lover picks B over A • This results in a pooling equilibrium. Profit Sharing Rate in percentages Profit sharing points of Equal profit to the firm Slide 18

Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary A Indifference curve for the risk lover C Profit Sharing Rate in percentages • Consider the choice between job offer A and C • The Risk Lover picks Contract C • The Risk Averse worker picks Contract A • Now we have separating equilibrium. Profit sharing points of Equal profit to the firm Slide 19

Choosing the Efficient Organizational Form • A reliant asset is at least partially non-redeployable Choosing the Efficient Organizational Form • A reliant asset is at least partially non-redeployable durable asset. » Specialized equipment or specialized knowledge cannot be transferred to other uses. • In markets with reliant assets, one party could “hold-up” the other party. The choice of organization will require explicit contracts. • The likely outcome is franchise contracts or vertical integration. • Relational contracts are promissory agreements of coordinated performance. » Pepsi selling Starbucks cold frappuccino in Pepsi vending machines is a relational contract or alliance agreement. Slide 20

The Efficient Organizational Form Depends on Asset Characteristics Table 15. 3 Fully Redeployable Durable The Efficient Organizational Form Depends on Asset Characteristics Table 15. 3 Fully Redeployable Durable Assets Nonredeployable Reliant Assets Not Dependent on Unique Complements Spot market recontracting Long-term supply contracts + risk management One-Way Dependent Assets Relational contracts (alliances) Vertical integration Bilateral Dependent Assets Relational contracts (joint ventures) Fixed profit-sharing contracts Slide 21

Prospect Theory Motivates Full-Line Forcing • Utility theory in economics is based on the Prospect Theory Motivates Full-Line Forcing • Utility theory in economics is based on the LEVEL of wealth or income received. More money leads to higher satisfaction or utility. • But Prospect theory is based on the choice relative to a base point. The difference (or the prospect) is categorized as either a gain or loss. • Buy now, pay later has both a gain (the goods now) and the loss (the pay later) • A car purchase as a “loss” of the money paid, but as a “gain” if you think you got a good deal. It can also help explain why manufacturers offer many versions (a full-line) of automobiles to get the customer to trade up to a pricier version. Slide 22

Prospect Theory & Full-Line Forcing: Figure 15. 5 Town & Country Minivan +140 +100 Prospect Theory & Full-Line Forcing: Figure 15. 5 Town & Country Minivan +140 +100 Caravan SXT $17, 000 Losses VALUE FUNCTION -160 $22, 000 $27, 000 $32, 000 Gains Full Option Caravan Base SE • With full options, the Caravan costs $22, 000. Other prospects viewed from this. • Moving down to the Base SE version is viewed as a loss of 160 in value, but at $5, 000 less. The customer decides to move up to the Full Option Caravan. • Moving up to a Caravan SXT costs another $5, 000, with a gain of 100 value. Slide 23

Uses for Prospect Theory • It helps explains why companies pay dividends • It Uses for Prospect Theory • It helps explains why companies pay dividends • It explains packaging that says, 35% more for free. » Gains should be separated with » Separate gains and four checks a year. losses, to create a Silver • It explains why companies Lining. announce all the bad news at • It explains why we one time » Bundle all the negative prospects together • It explains the purchases of $750 stereos in Cars » Bundled together wrap Christmas and Birthday gifts separately » Separate gains. Slide 24

Vertical Integration • Vertical integration is a way to avoid transaction costs, such as Vertical Integration • Vertical integration is a way to avoid transaction costs, such as moral hazard, which are found in arm's length (or market) dealing. • The two stages of production are merged. The producer ships goods to the next stage of the same firm. • If each stage of production has some monopoly power, the profits can be higher by merging the two stages. Slide 25

Vertical Integration in the Hosiery Market P h’ Ph P y’ Py • Suppose Vertical Integration in the Hosiery Market P h’ Ph P y’ Py • Suppose yarn is used in making hosiery (socks) in fixed proportions. • Let the marginal cost of yarn (MCy) and hosiery Py’ +MCh manufacture (MCh) be MCy +MCh constant. • The profit maximizing MCh hosiery price is Ph Higher yarn prices • But if the price of yarn is raised to Py’ the price MCy ends up too high at Ph’ MRh DEMAND with smaller total profits Quantity (lbs. ) for the hosiery + yarn industries. Figure 15. 6 Slide 26

Mergers with Upstream Competitors • Hence, if one firm manufactured yarn and another firm Mergers with Upstream Competitors • Hence, if one firm manufactured yarn and another firm manufacturer hosiery, the merged firm could be run optimally and be more profitable than separate firms. • This is a reason why firms often expand vertically (or backward to earlier stages of production). » If the hosiery firm buys a yarn maker, this is viewed as backward integration, going backward “upstream” in the manufacturing process. Slide 27

Dissolution • Integration combines assets, but often conglomerate firms find it in their interest Dissolution • Integration combines assets, but often conglomerate firms find it in their interest to sell assets and to get back to their core businesses. • Suppose a partnership wants to divide up the assets, but in doing so, the market may wish only to pay highly discounted prices • Suppose the whole firm is worth $3 million, and Joe and Kim want to divide it. • If both agree, the deal goes through. • If either disagrees, the value of the whole shrinks by $1 million at EACH disagreement. What happens? Slide 28

Dissolution of a Partnership Figure 15. 8 – Joe’s Payoffs are listed first in Dissolution of a Partnership Figure 15. 8 – Joe’s Payoffs are listed first in each pair Joe 1 Offer to Split Accepts {$900, 000; $2. 1 million} Kim 1 REFUSES Offer Kim 2 Accepts {$500, 000, $1. 5 mil. } Joe 2 Accepts to {$400, 000; $600, 000} REFUSES Split Offer Looking to end-game reasoning, Joe 3 to Kim disagreements end in disaster { 0, 0 }. Split 3 So, Joe offers to give Kim $2. 1 million, and Kim will accepts it. Joe gets $900, 000. REFUSES { 0; 0 } Slide 29