Economics of Management Strategy BEE3027

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Economics of Management StrategyBEE3027

• Lecture 2

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Recap

• Last week we covered the basic arguments for why
  production may be organised within the firm
  vis-à-vis outsourcing production.
• We looked at the neo-classical view of the firm
  and the scale scope advantages of size.
• We looked at how resorting to spot markets or
  long-term contracts on product-specific inputs
  may result in the hold up problem.

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Vertically Integrated Production

• We now focus our attention to the firm.
• The more specific the transaction, the greater
  the incentive to produce in-house, rather than to
  outsource.
• There are several reasons why firms may want to
  vertically integrate.

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Vertically Integrated Production

• There are two important differences to vertically
  integrated production vis-à-vis outsourcing
• Different ownership structure
• Difference governance structure.
• Ownership of an asset is crucial in a world of
  incomplete contracts.
• It determines residual controls rights over the
  asset.

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Vertically Integrated Production

• In other words, in an unforeseen event, the owner
  determines the use of the asset.
• This solves (part of) the hold-up problem.
• Differences in the governance are also important,
  especially from a legal perspective
• Legal obligations of employees are different than
  those of a supplier
• Contractual disagreements are solved internally
  rather than in court (lower costs).

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Vertically Integrated Production

• The owner of the firm has rights
• To be the residual claimant
• To hire/purchase production inputs (i.e. labour
  capital)
• To monitor/oversee factors of production
• To change the factors of production
• To sell these rights.

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Principal-Agent Problem

• Take the example of a manager who hires a worker
  to perform a given task.
• The manager naturally wants the worker to work as
  hard as possible to raise revenue
• The worker, however dislikes working and will
  shirk if possible.

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Principal-Agent Problem

• Suppose for simplicity, that our worker can
  either work hard or not work at all.
• Worker effort, e, is either equal to 2 or 0.
• U w e if worker takes the job
• U 10 if he works somewhere else.

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Principal-Agent Problem

• Firm profits are a function of how hard the
  worker works.
• ? H w if e 2
• ? L w if e 0
• What contract should the owner offer the worker
  in order to maximise profit?

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Principal-Agent Problem

• Since the owner cannot observe effort, he must
  set the wage based on revenues (H or L).
• Wh is the wage when revenue is H
• Wl is the wage when revenue is L
• There are two constraints the owner must consider
  when setting wages
• It must be worth for the worker to take the
  contract
• The contract must provide the incentive to work
  hard

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Principal-Agent Problem

• Since the worker can make at least 10 if he goes
  somewhere else
• Wh 2 10 participation constraint
• The contract must be done in such a way as for
  the worker to have higher utility by working
  hard
• Wh 2 Wl 0 incentive constraint

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Principal-Agent Problem

• Therefore, the optimal contract is Wh 12 and Wl
  10.
• This means profits for the owner are
• H 12 if e 2
• L 10 if e 0.
• This means that in order for the contract to be
  optimal for the owner
• H 12 L 10 ltgt H L 2.

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Principal-Agent Problem

• This is a rather easy way to solve a very
  complicated problem
• It is simple because worker effort can be
  directly inferred from revenues.
• In a sense, owner can directly monitor worker
• What happens when worker productivity is
  uncertain (and monitoring is imperfect)?

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Principal-Agent Problem

• Profits, ?(e) are given by
• ?(2) H w with prob 0.8
• ?(2) L w with prob 0.2
• ?(0) H w with prob 0.4
• ?(0) L w with prob 0.6
• Now, working hard only increases the likelihood
  of higher revenue.

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Principal-Agent Problem

• Workers utility is given by
• U EW e if worker takes the job
• U 10 if he works somewhere else.
• EW 0.8Wh 0.2Wl when e 2
• EW 0.4Wh 0.6Wl when e 0

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Principal-Agent Problem

• The uncertainty has an impact in both
  participation and incentive constraints
• PC 0.8Wh 0.2Wl 2 10
• IC 0.8Wh 0.2Wl 2 0.4Wh 0.6Wl 0
• PC implies Wl 60 4Wh
• IC implies Wl Wh 5.
• Solving two equations gives Wh 13, Wl 8

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Principal-Agent Problem

• How much does it cost to implement this type of
  contract?
• Expected cost to entrepreneur is
• 0.8130.28 12
• Under symmetric information and certainty
• Wh 12, Wl10.
• Hence, the contract does away with the need to
  monitor worker.

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Principal-Agent Problem

• Lets introduce a further twist in this story.
  Lets suppose that the worker is more skeptical
  about the likelihood of H occurring if e 2.
• In particular, the worker assigns a different
  probability to H occurring if he sets e2, s.t.
• ?(2) H w with prob 0.7
• ?(2) L w with prob 0.3

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Principal-Agent Problem

• The worker will now have a different expected
  wage than the owner for any Wh, Wl
• PC is now given by
• 0.7Wh 0.3Wl - 2 10 gtWh (12 - 0.3Wl)/0.7
• IC is now given by
• 0.7Wh 0.3Wl - 2 0.4Wh 0.6Wl 0 ltgt Wh
  2/0.3 Wl

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Principal-Agent Problem

• The owner will choose a contract which minimises
  his wage costs 0.8Wh0.2Wl
• (remember that the owner has different subject
  probs over the different states of the world)
• In equilibrium, Wh 14, Wl 22/3
• Expected wage bill is equal to
• 0.8140.222/312.66 gt 12

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Principal-Agent Problem

• The expected wage in equilibrium is higher than
  the workers reservation wage plus effort level.
• The rationale behind this result is that the
  worker must be compensated for taking a
  random-wage contract.
• The difference is a risk-aversion premium.

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Alternative contractual solutions

• Performance-related pay.
• Piece rates. In other words, workers get w for
  each unit (q) they produce.
• This type of contract goes back to Taylor in the
  XIX century it is still widely used in the
  agricultural sector.
• Individuals will work until MC(q) w.

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Alternative contractual solutions

• However, how does one set w?
• If w is set based on previous performance, there
  is a moral hazard problem workers have an
  incentive to underperform.
• Also, the applicability of piece rates is limited
  to agricultural or industrial contexts.

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Alternative contractual solutions

• Another alternative is to pay workers based on
  their relative performance
• Promotion Tournaments.
• These contracts work much like sports
  competitions
• The individual who is more productive wins either
  a bonus or a promotion.
• A variant of this type of contract was in place
  at GE under their former CEO, Jack Welsh. Every
  year, the bottom 10 managers would be sacked!

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Tournaments

• Consider a firm with 2 workers.
• Their probability of success depends on both
  workers effort, which is costly
• High effort has a cost of 1.
• Table outlines the probability of success for
  each player as a function of effort.

High effort Low effort
High effort 1/2,1/2 3/4,1/4
Low effort 1/4,3/4 1/2,1/2
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Tournaments

• If both players are paid the same, then the Nash
  equilibrium of this game is for both players to
  submit zero effort
• (why? This is a homework question.)
• However, if the winner of the tournament is paid
  sufficiently highly (relative to the loser), then
  the unique Nash equilibrium is for both players
  to submit high effort.

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Alternative contractual solutions

• Another possibility is to set a fixed target to a
  team.
• If achieved, bonus is shared by the group.
• If not, each group member is paid a basic wage,
  which is typically low (unless you are an
  investment banker).
• Target-based schemes are very popular in the
  services industry (e.g. retail, inv. banking).

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Alternative contractual solutions

• How do these types of contracts compare?
• Bandiera et al. (2006) compare piece rates to a
  productivity-based compensation contract.
• Wage ßK, where K is amount of fruit picked by
  worker and ß w/y.
• w minimum wage constant,
• y mean daily productivity of group.

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Bandiera et al. (2006)

• Under this contract, working hard implies (all
  else constant)
• Higher earnings (K ?)
• Increases average effort, thus increasing average
  productivity (y ?), which in turn lowers earnings
  for everyone else.
• This contract has a PG game aspect to it, since
  it contrasts the individual gain vs. the
  detrimental effect to other group members.
• The relative performance contract was introduced
  to control for productivity shocks (e.g. weather
  conditions).

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Bandiera et al. (2006)

• Paper looks at worker productivity under piece
  rates and relative performance scheme.
• Farm workers were temporary workers from outside
  the UK.
• Productivity under piece rates was 50 higher
  than under relative performance scheme.
• The reason is that social norms are created among
  co-workers, promoting cooperation (i.e. lower
  effort).

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Bandiera et al. (2006)

• Given heterogeneity in backgrounds, they find
  that individuals who have higher piece rates work
  harder.
• Although piece rate is equal across workers, the
  value in local currency of each worker will be
  different.
• The larger the value of the piece rate as a
  function of average salary in home country, the
  higher the productivity of the worker.

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Alternative contractual solutions

• Bull, Schotter and Weigelt (1987) compare
  tournaments to piece rates in controlled
  experiments.
• They find that, on average, subjects effort is
  close to what theory would predict.
• However, they find that behaviour in tournaments
  is much more variable.

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Alternative contractual solutions

• Nalbantian and Schotter (1997) compare a number
  of group incentive institutions
• Tournaments
• Revenue sharing
• Target-based schemes.
• They find that
• Relative performance schemes more effective than
  target based schemes
• Monitoring is effective but very costly.

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Alternative contractual solutions

• Müller and Schotter (2003) study tournaments
  where they manipulate individual subject ability.
• They find that
• High ability subjects work harder than predicted
• Low ability subjects simply drop out.
• So, relative performance mechanisms may lead to
  dropout/workaholic behaviour.
• Even if total output is higher, it is unclear
  whether it is desirable to have such a corporate
  culture.

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Alternative contractual solutionsOverview

• Piece rates appear to be useful tools to boost
  productivity.
• However, their applicability is limited.
• While tournaments can be useful alternatives,
  they lead to high variability in worker
  behaviour.

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Team production
Smallest Number in Your Group Smallest Number in Your Group Smallest Number in Your Group Smallest Number in Your Group Smallest Number in Your Group Smallest Number in Your Group Smallest Number in Your Group
7 6 5 4 3 2 1
Your number 7 130 110 90 70 50 30 10
Your number 6 - 120 100 80 60 40 20
Your number 5 - - 110 90 70 50 30
Your number 4 - - - 100 80 60 40
Your number 3 - - - - 90 70 50
Your number 2 - - - - - 80 60
Your number 1 - - - - - - 70
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Minimum-effort game

• The game we just played is called the
  minimum-effort game.
• In certain activities, the productivity of a
  given worker or department depends on the
  productivity of the worker/department in the
  previous step of the production process.
• It captures two key ideas in team production
• Public good problem
• Coordination problem.

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Minimum-effort game

• This game has a very large number of equilibria
  in pure strategies
• In all equilibria, all players choose the same
  level of effort.
• Although theoretically, individuals should be
  able to coordinate on the maximum amount, they
  often dont.

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Minimum-effort game

• The reason is that the equilibrium where all
  players choose 7 is very risky.
• If by chance, one player decides not to play 7,
  all players can lose up to 110 points, while that
  player will only lose up to 50!
• On the other hand, the equilibrium where all
  choose 1 is quite safe there is no way you can
  lose money.

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Minimum-effort game

• This problem increases the larger the group size

Studies Group size Country Average e
Van Huyck et al. (1990). 2 USA 6.250
Weber et al. (2004) Knez Camerer (1994, 2000). 3 USA 3.074 5.188
Dufwenberg Gneezy (2005) Knez Camerer (1994) 6 ISR, USA 5.357
Bornstein et al. (2002) 7 SP 1.667
Van Huyck et al. (1990). 14-16 USA 1
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Summary

• Property-rights motivation for existence of
  firms
• Team production
• Compensation schemes
• Coordination problem in production
• Next week
• Managerial compensation.
• Pricing and marketing strategies.