Bo Com Lectures

BoCOM LecturesBoCOM Lectures

Jiahua CheJiahua Che

University Of IllinoisUniversity Of Illinois

March 4, 6, & 11March 4, 6, & 11

IntroductionIntroduction

Purposes of the Lecture SeriesPurposes of the Lecture Series

– Concepts and ways of thinking, no panacea Concepts and ways of thinking, no panacea

CautioningCautioning

– Role switching between banker and managerRole switching between banker and manager

– We will at times abstract to highlight key economic intuitions behind We will at times abstract to highlight key economic intuitions behind certain conceptscertain concepts

– Some discussions might therefore appear artificialSome discussions might therefore appear artificial

Private Mechanism Private Mechanism v.sv.s Government InterventionGovernment Intervention

Boundaries of Government InterventionBoundaries of Government Intervention

– One of the defining characteristics of the Chinese economy is the heavy One of the defining characteristics of the Chinese economy is the heavy government involvementgovernment involvement

– There are pros and cons for government involvement in economic There are pros and cons for government involvement in economic activitiesactivities

– The issue is what defines the boundaries of government interventionThe issue is what defines the boundaries of government intervention


Outside government intervention Outside government intervention

– Economic activities are carried out through private mechanismEconomic activities are carried out through private mechanism

– Private mechanism includes market mechanismPrivate mechanism includes market mechanism

Government intervention

Market mechanism

Private mechanism


Examples of Non-Market Private MechanismExamples of Non-Market Private Mechanism

– Market mechanism here refers to traditional arms-length, anonymous, Market mechanism here refers to traditional arms-length, anonymous, nucleus, transactionsnucleus, transactions

– Non-market private mechanism includesNon-market private mechanism includes

» Explicit or implicit contractual arrangementExplicit or implicit contractual arrangement

» Informal agreement supported by trust and reputationInformal agreement supported by trust and reputation

» Non-government-owned firms and organizations Non-government-owned firms and organizations


Externality and Government InterventionExternality and Government Intervention

– Externality is often thought of as a case for government interventionExternality is often thought of as a case for government intervention

– Externality:Externality:

» Refers to a situation where one person’s action affects another Refers to a situation where one person’s action affects another person’s well-being, which is not accounted for by market mechanism person’s well-being, which is not accounted for by market mechanism

– Example of externality: Example of externality:

» 麻将 and neighbors


The The 麻将 -neighbors problem

– You love tranquility but your neighbor loves 麻将

– Assumptions:

» Without 麻将 , your well being is valuated at X, your neighbor’s well being is at Y

» With 麻将 , your well being is valuated at X - a, your neighbor’s well being is at Y + b

» Loss in well being can be compensated through monetary transfer

» Both you and your neighbor have lots of money


The The 麻将 -neighbors problem and Coase Theorem

– The efficient outcome» Efficient outcome: no alternative universally preferred by people

involved» 麻将 to be played if X + Y < X – a + Y + b, or b > a» 麻将 to be played otherwise

– Private contractual arrangementPrivate contractual arrangement» I: your neighbor may pay you “to be allowed” to play I: your neighbor may pay you “to be allowed” to play 麻将 , or» II: you may pay your neighbor for his “right” to play 麻将» Key: there is a right associated with playing 麻将 , this right may be

initially allocated to you (I) or to your neighbor (II)


The The 麻将 --neighbors problem and Coase TheoremCoase Theorem

– Regardless how the right is initially allocated, the outcome emerging from Regardless how the right is initially allocated, the outcome emerging from the private contractual arrangement is the efficient outcomethe private contractual arrangement is the efficient outcome

– (1) The outcome through private contracting is efficient (1) The outcome through private contracting is efficient

– (2) Allocation of property rights does not affect the outcome(2) Allocation of property rights does not affect the outcome


The The 麻将 -neighbors problem and Coase TheoremCoase Theorem

– Suppose b > a Suppose b > a

– If you initially have the right, your well-being (after compensation) may If you initially have the right, your well-being (after compensation) may be X + b – a; if your neighbor initially has the right, your well-being (after be X + b – a; if your neighbor initially has the right, your well-being (after compensation) may be X compensation) may be X

– (3) Allocation of property rights affects redistribution: separation between (3) Allocation of property rights affects redistribution: separation between efficiency and redistributionefficiency and redistribution

DiscussionDiscussion

ApplicationApplication

– The case of bank operationThe case of bank operation

» Bank lending unprofitable yet helpful to local economyBank lending unprofitable yet helpful to local economy

Keys to Coase TheoremKeys to Coase Theorem

– Well-defined and enforced property rightsWell-defined and enforced property rights

– Flexibility in prices: emphasizing the role of prices Flexibility in prices: emphasizing the role of prices

Introducing Contractual DifficultiesIntroducing Contractual Difficulties

Barriers to Perfect Contracting and Limits to Coase Theorem Barriers to Perfect Contracting and Limits to Coase Theorem

– Information asymmetry Information asymmetry

» Parties to a transaction may be differently informed concerning the Parties to a transaction may be differently informed concerning the nature of the transaction, either nature of the transaction, either ex ante ex ante or or ex postex post

– Contractual renegotiationContractual renegotiation

» Parties to a transaction may choose to rearrange terms of the Parties to a transaction may choose to rearrange terms of the transaction in the middle of the transactiontransaction in the middle of the transaction

– Contract renegingContract reneging

» One party may choose not to abide the terms of the transactionOne party may choose not to abide the terms of the transaction

– Contractual incompletenessContractual incompleteness

» Some scenarios relevant to a transactions may not be covered in the Some scenarios relevant to a transactions may not be covered in the initial contractinginitial contracting

The limits to the Role of PricesThe limits to the Role of Prices

The Case of Credit Rationing and Information AsymmetryThe Case of Credit Rationing and Information Asymmetry

– Example: Example:

» Two borrowers, each want to borrow $1 from you to invest on a Two borrowers, each want to borrow $1 from you to invest on a project project

» You, a banker, has only $1You, a banker, has only $1

» Should you lend the $1 to whoever bids the highest interest rate? Should you lend the $1 to whoever bids the highest interest rate?

– Assumption:Assumption:

» One borrower has a risky project, which has return Q with prob q and One borrower has a risky project, which has return Q with prob q and 0 with prob 1 - q0 with prob 1 - q

» The other has a safe project, which has return R with prob 1The other has a safe project, which has return R with prob 1

The limits to the Role of PricesThe limits to the Role of Prices

The Case of Credit Rationing and Information AsymmetryThe Case of Credit Rationing and Information Asymmetry

– Assumption:Assumption:

» R(1 + q)/2 > qQ and Q > RR(1 + q)/2 > qQ and Q > R

» Limited liabilityLimited liability

» You don’t know who has a risky project and who has a safe oneYou don’t know who has a risky project and who has a safe one

– Analysis Analysis

» Let r be the interest rateLet r be the interest rate

» If lend to the highest bidder, you will be lending to the risky project. If lend to the highest bidder, you will be lending to the risky project. Your expected profit = q(1 + r) Your expected profit = q(1 + r) qQ qQ

» If limit the interest rate so that 1 + r = R, you ration $1 between the If limit the interest rate so that 1 + r = R, you ration $1 between the two borrowers. Your expected profit = R(1/2 + q/2) > qQ two borrowers. Your expected profit = R(1/2 + q/2) > qQ

Contracting with Information AsymmetryContracting with Information Asymmetry

Pre-contractual OpportunismPre-contractual Opportunism

– Example: parties may have different private information regarding the Example: parties may have different private information regarding the nature of the transaction (adverse selection)nature of the transaction (adverse selection)

Post-contractual opportunism Post-contractual opportunism

– Example: parties take unobservable actions post-contracting Example: parties take unobservable actions post-contracting

(moral hazard)(moral hazard)

Pre-Contractual Opportunism & Pre-Contractual Opportunism & Contractual ResponsesContractual Responses

Adverse SelectionAdverse Selection

– The origin of the term and the idea of the conceptThe origin of the term and the idea of the concept

» The case of insuranceThe case of insurance

– The consequence of adverse selection:The consequence of adverse selection:

» When adverse selection becomes very serious, the markets may When adverse selection becomes very serious, the markets may collapse. collapse.


Adverse SelectionAdverse Selection

– Example: The “lemon” problemExample: The “lemon” problem

» In used car market, qualities of used cars vary, known to owners but In used car market, qualities of used cars vary, known to owners but to buyersto buyers

» Buyers pay price according to average used car quality on marketBuyers pay price according to average used car quality on market

» Owners of better quality used car to withdraw from the market, Owners of better quality used car to withdraw from the market, leaving only used cars of below-average quality to stayleaving only used cars of below-average quality to stay

» Average quality is lowered and buyers pay lower price …. Average quality is lowered and buyers pay lower price ….

– A similar example:A similar example:

» Bad coins drive out good coinsBad coins drive out good coins


Contractual Responses to Adverse SelectionContractual Responses to Adverse Selection

– RationingRationing

– Limiting parties’ choices Limiting parties’ choices

» bundled insurance and universal coveragebundled insurance and universal coverage

» Automobile leasingAutomobile leasing

– Preventing information gathering in the first place Preventing information gathering in the first place



– SignalingSignaling

» Privately informed parties adopt behaviors that reveal their Privately informed parties adopt behaviors that reveal their information; in response, the contract incorporates these behaviors information; in response, the contract incorporates these behaviors that otherwise may be irrelevant to the transaction that otherwise may be irrelevant to the transaction

– Screening Screening

» Uninformed parties take actions to separate different types of Uninformed parties take actions to separate different types of privately informed parties along certain dimension; typically done privately informed parties along certain dimension; typically done through a menu of alternatives, each intended for a particular type of through a menu of alternatives, each intended for a particular type of these informed partiesthese informed parties



– How does signaling work: the advertisement exampleHow does signaling work: the advertisement example

» Image a situation where products are of high or low qualityImage a situation where products are of high or low quality

» Suppose that in such an environment, manufactures of high quality Suppose that in such an environment, manufactures of high quality products make costly advertisement; while manufactures of low products make costly advertisement; while manufactures of low quality products do not advertisequality products do not advertise

» In this case, buyers will buy advertised products at a premium, since In this case, buyers will buy advertised products at a premium, since advertisement reveals products being of high qualityadvertisement reveals products being of high quality


Contractual Responses and Self SelectionContractual Responses and Self Selection

– The advertisement example continuedThe advertisement example continued

» Why manufactures of high quality products will advertise but those of Why manufactures of high quality products will advertise but those of low quality products do not?low quality products do not?

» The key is to realize: if product quality can be differentiated, high The key is to realize: if product quality can be differentiated, high quality product manufactures can make more profits than low quality quality product manufactures can make more profits than low quality product manufactures. product manufactures.

» In this case, the former can spend cost in advertisement and still In this case, the former can spend cost in advertisement and still remain profitable, while the latter cannot do so. remain profitable, while the latter cannot do so.

» The interesting thing is when the former makes costly advertisement The interesting thing is when the former makes costly advertisement but the latter does not, product quality is differentiated!but the latter does not, product quality is differentiated!



– Illustration of the advertisement exampleIllustration of the advertisement example

» Suppose without quality differentiation, profits for each manufacture Suppose without quality differentiation, profits for each manufacture = $100. Suppose with quality differentiation, profits for high quality = $100. Suppose with quality differentiation, profits for high quality product manufacture = $200, profit for low quality product product manufacture = $200, profit for low quality product manufacture = $50. Finally, assume cost of advertisement = $80manufacture = $50. Finally, assume cost of advertisement = $80

» In this environment, low quality product manufacture will never In this environment, low quality product manufacture will never advertise, since 100 - 80 < 50advertise, since 100 - 80 < 50

» Given that low quality product manufacture will not advertise, high Given that low quality product manufacture will not advertise, high quality product manufacture will indeed advertise, since 200 - 80 > quality product manufacture will indeed advertise, since 200 - 80 > 100100



– How does signaling work: the essenceHow does signaling work: the essence

» The key to signaling is that a contract incorporates observed The key to signaling is that a contract incorporates observed behaviors from which private information is revealedbehaviors from which private information is revealed

» Such information revelation must be credible, which in this case Such information revelation must be credible, which in this case means that the behaviors must be adopted by some (e.g. high quality means that the behaviors must be adopted by some (e.g. high quality product manufacture) but not by others (e.g., low quality product product manufacture) but not by others (e.g., low quality product manufacture)manufacture)

» This condition is known as the self-selection conditionThis condition is known as the self-selection condition

» In other words, signaling works only when the self-selection In other words, signaling works only when the self-selection condition is metcondition is met



– Illustration of the self-selection conditionIllustration of the self-selection condition

» Consider the advertisement example. Now suppose without quality Consider the advertisement example. Now suppose without quality differentiation, profits for each manufacture = X. Suppose with differentiation, profits for each manufacture = X. Suppose with quality differentiation, profits for high quality product manufacture = quality differentiation, profits for high quality product manufacture = H, profit for low quality product manufacture = L. Finally, assume H, profit for low quality product manufacture = L. Finally, assume cost of advertisement = Ycost of advertisement = Y

» Advertisement is a credible signal if and only if the high quality Advertisement is a credible signal if and only if the high quality product manufacture is willing to advertise while the low quality product manufacture is willing to advertise while the low quality product manufacture is notproduct manufacture is not

» This means: H - Y > X (high quality product manufacture prefers ad This means: H - Y > X (high quality product manufacture prefers ad to not) and L > X - Y (low quality product manufacture prefers not to to not) and L > X - Y (low quality product manufacture prefers not to ad to ad). ad to ad).



– Self-selection and screening Self-selection and screening

» Credible information revelation is also the key to screeningCredible information revelation is also the key to screening

» Therefore screening works only the self-selection condition holds, in Therefore screening works only the self-selection condition holds, in which case each party finds it optimal to choose the alternative which case each party finds it optimal to choose the alternative intended for itintended for it



– Example of self-selection in screeningExample of self-selection in screening

» The firm, which is a monopoly, offers two contractsThe firm, which is a monopoly, offers two contracts

» In contract 1, buyers pay for In contract 1, buyers pay for

product at price pproduct at price p11 but but has to has to

buy at least qbuy at least q11 amount amount

» In contract 2, buyers pay for In contract 2, buyers pay for

product at price pproduct at price p22Contract 1: (p1, q1)

Contract 2: (p2)p2

p1

q1q2



– Example of self-selection in screening continuedExample of self-selection in screening continued

» Contract 1 is intended for buyers represented by green demand curveContract 1 is intended for buyers represented by green demand curve

» Contract 2 is intended for buyers represented by rend demand curveContract 2 is intended for buyers represented by rend demand curve

» Clearly, green buyers will not choose contract 2 and red buyers will Clearly, green buyers will not choose contract 2 and red buyers will not choose contract 1not choose contract 1

» Therefore, even though the firm does not know buyers’ types, it Therefore, even though the firm does not know buyers’ types, it induces buyers to self-select and hence to reveal their own types by induces buyers to self-select and hence to reveal their own types by offering these two different contractsoffering these two different contracts

» And as the diagram shows, the firm maximizes its profits with respect And as the diagram shows, the firm maximizes its profits with respect to each of these two kinds of buyersto each of these two kinds of buyers


Efficiency in Contractual ResponsesEfficiency in Contractual Responses

– Despite contractual responses, efficient outcome may not achievedDespite contractual responses, efficient outcome may not achieved

» Example: costly advertisementExample: costly advertisement

– In some cases, contractual “responses” could make things even worseIn some cases, contractual “responses” could make things even worse


Efficiency in Contractual Responses to Adverse SelectionEfficiency in Contractual Responses to Adverse Selection

– Example: screening and statistical discriminationExample: screening and statistical discrimination

» Employers believe women below age 35 unproductive and choose not Employers believe women below age 35 unproductive and choose not to hireto hire

» Because women below age 35 are not hired, such belief, even if false, Because women below age 35 are not hired, such belief, even if false, is not contested: efficiency loss #1is not contested: efficiency loss #1

» Expecting not to be employed after age 35, women do not make long-Expecting not to be employed after age 35, women do not make long-term investment in skills: efficiency loss #2term investment in skills: efficiency loss #2

» Self-fulfilling: but the employee’s belief is confirmedSelf-fulfilling: but the employee’s belief is confirmed

» Government intervention called for? Government intervention called for?

Post-Contractual Opportunism & Post-Contractual Opportunism & Contractual ResponsesContractual Responses

Moral HazardMoral Hazard

– The idea of the conceptThe idea of the concept» Actions involved in a transaction are not always observable and Actions involved in a transaction are not always observable and

therefore Efficient actions not freely observable and as a result parties therefore Efficient actions not freely observable and as a result parties taking them may choose to purse their own interests at others’ expensetaking them may choose to purse their own interests at others’ expense

– Two forms of moral hazard:Two forms of moral hazard:» Parties may take inefficient actionsParties may take inefficient actions» Parties may provide false information (leading others to take inefficient Parties may provide false information (leading others to take inefficient

actions)actions)

– The origin of the term and its moral/efficiency connotationThe origin of the term and its moral/efficiency connotation


Moral HazardMoral Hazard

– Incidence of moral hazardIncidence of moral hazard

» Moral hazard is often thought as taking place in principal-agent Moral hazard is often thought as taking place in principal-agent relation, where the agent acts on behalf of the principal and is relation, where the agent acts on behalf of the principal and is supposed to advance the principal’s interest supposed to advance the principal’s interest

– Examples of moral hazardExamples of moral hazard

» Employee shirkingEmployee shirking

» Managerial misbehaviorManagerial misbehavior

» FraudFraud

» CorruptionCorruption


Controlling Moral Hazard: MonitoringControlling Moral Hazard: Monitoring

– Role of monitoringRole of monitoring

» Preventing bad behaviors from happeningPreventing bad behaviors from happening

» Providing basis for reward and punishmentProviding basis for reward and punishment

– Ways of monitoringWays of monitoring

» ex ante, interim, and ex post monitoringex ante, interim, and ex post monitoring

» Monitoring through competing sources: the case of department storesMonitoring through competing sources: the case of department stores

» Peer monitoring with group incentives Peer monitoring with group incentives

» Monitoring by marketsMonitoring by markets


Controlling Moral Hazard: Incentive ContractsControlling Moral Hazard: Incentive Contracts

– How incentive contracts provide incentivesHow incentive contracts provide incentives

» Contracts link reward to agents to their performance while agents’ Contracts link reward to agents to their performance while agents’ actions determine their performanceactions determine their performance

» e.g. workers’ pay linked to output/profits which in turn determined by e.g. workers’ pay linked to output/profits which in turn determined by workers’ efforts workers’ efforts

– Keys to provide incentivesKeys to provide incentives

» In providing incentives, it is not the level of reward that mattersIn providing incentives, it is not the level of reward that matters

» It is the margin (i.e., the difference between reward when It is the margin (i.e., the difference between reward when performance is good and reward when performance is bad) that performance is good and reward when performance is bad) that mattersmatters



– Risk-bearing and incentive provisionRisk-bearing and incentive provision» Existence of moral hazard has to do with the stochastic relation Existence of moral hazard has to do with the stochastic relation

between performance and behaviors, because without stochastic between performance and behaviors, because without stochastic elements, perfect contracting will be feasibleelements, perfect contracting will be feasible

» Therefore risk bearing by the agents is inevitable in incentive Therefore risk bearing by the agents is inevitable in incentive provisionprovision

» Optimal incentive contract must balance incentives and risksOptimal incentive contract must balance incentives and risks



– Incentive contract and “statistical inference”Incentive contract and “statistical inference”

» Incentive contract works in a way as if the principal uses performance Incentive contract works in a way as if the principal uses performance measures to estimate the actions chosen by the agent and assign measures to estimate the actions chosen by the agent and assign payments accordinglypayments accordingly



– Example:Example:» Setting: Setting:

probability(good performance | high effort ) = pprobability(good performance | high effort ) = p probability(good performance | high effort ) = qprobability(good performance | high effort ) = q» ““Statistical inference” Statistical inference”

If high performance is observed, one can estimate the likelihood that If high performance is observed, one can estimate the likelihood that the agent “has exerted high effort”, i.e., the agent “has exerted high effort”, i.e., probability(high effort | good performance) probability(high effort | good performance) similarly, if bad performance is observed, one can estimate the similarly, if bad performance is observed, one can estimate the likelihood that the agent “has exerted low effort”, i.e.,likelihood that the agent “has exerted low effort”, i.e.,probability(low effort | bad performance) probability(low effort | bad performance)



– Example:Example:» Clearly, how large a margin the principal will provide depends on Clearly, how large a margin the principal will provide depends on

these two probabilities: these two probabilities: probability(high effort | good performance) and probability(high probability(high effort | good performance) and probability(high effort | bad performance)effort | bad performance)

» For example, if the two probabilities are close, then the principal For example, if the two probabilities are close, then the principal cannot tell whether good performance indicates high effort, in which cannot tell whether good performance indicates high effort, in which case the margin in the agent’s pay should be minimalcase the margin in the agent’s pay should be minimal

» The difference in these two probabilities represent the precision in the The difference in these two probabilities represent the precision in the “statistical inference”“statistical inference”



– Incentive contract and “statistical inference”Incentive contract and “statistical inference”

» The margin should increase as the precision improvesThe margin should increase as the precision improves

– AS IF “statistical inference” AS IF “statistical inference”

» When a contract is actually given out, the agent chooses a particular When a contract is actually given out, the agent chooses a particular action under the contractaction under the contract

» In particular, if the contract is effective, the agent will in fact choose In particular, if the contract is effective, the agent will in fact choose high efforthigh effort

» There is no statistical inference in actuality, except the contract is There is no statistical inference in actuality, except the contract is designed as if one makes “statistical inference”designed as if one makes “statistical inference”



– The incentive-intensity principle: The incentive-intensity principle:

» How large the margin should be depends on (1) agent’s risk tolerance, How large the margin should be depends on (1) agent’s risk tolerance, (2) precision in which agent’s action is estimated, (3) the importance (2) precision in which agent’s action is estimated, (3) the importance of the right action relative to the wrong actions, and (4) the agent’s of the right action relative to the wrong actions, and (4) the agent’s responsiveness to the margin responsiveness to the margin

– The informativeness principle: The informativeness principle:

» Include performance measures that allows reduce the error with Include performance measures that allows reduce the error with which the action is estimated; exclude performance measures that which the action is estimated; exclude performance measures that increase the error with which the action is estimatedincrease the error with which the action is estimated



– Monitoring intensity principle: Monitoring intensity principle:

» Devote more resources to monitoring the performance measure if it is Devote more resources to monitoring the performance measure if it is desirable to have more intensive incentivesdesirable to have more intensive incentives

– Balanced incentive principle: Balanced incentive principle:

» Suppose the agent allocates resources among different activities on Suppose the agent allocates resources among different activities on behalf of the principal and that such allocation cannot be monitored behalf of the principal and that such allocation cannot be monitored by the principal. Then equally intensive incentives should be offered by the principal. Then equally intensive incentives should be offered towards these activities, or resources will not be allocated to the towards these activities, or resources will not be allocated to the activity that is provided with weaker incentives activity that is provided with weaker incentives



– Application 1: Application 1:

» Comparative performance evaluation – tournamentComparative performance evaluation – tournament

– Application 2: Application 2:

» Job design and asset ownershipJob design and asset ownership

– Discussion: Discussion:

» Structuring incentives in the Chinese economyStructuring incentives in the Chinese economy


Rents, Efficiency, and Market CompetitionRents, Efficiency, and Market Competition

– Limits to monetary incentivesLimits to monetary incentives

» Incentive contracts sometimes require agents to pay cash penalty for Incentive contracts sometimes require agents to pay cash penalty for misbehaviors, but agents may be cash constrained to afford such misbehaviors, but agents may be cash constrained to afford such penaltypenalty

» A more subtle constraint comes when the performance evaluation is A more subtle constraint comes when the performance evaluation is subjectivesubjective



– Efficiency wage contractEfficiency wage contract

» An efficiency wage contract pays an agent (a worker in this case) a (fixed) An efficiency wage contract pays an agent (a worker in this case) a (fixed) wage higher than market-clearing wage if his performance is satisfactory, wage higher than market-clearing wage if his performance is satisfactory, and the contract is terminated otherwise and the contract is terminated otherwise

– Efficiency wage contract, termination and unemploymentEfficiency wage contract, termination and unemployment

» Suppose all firms face the same incentive problems. All will offer efficiency Suppose all firms face the same incentive problems. All will offer efficiency wage contracts. Then efficiency wage rate is also the market wage rate wage contracts. Then efficiency wage rate is also the market wage rate

» In order for termination to be “penalizing”, workers must risk being In order for termination to be “penalizing”, workers must risk being unemployed after terminationunemployed after termination

» In other words, labor market must not clear --- labor supply must be greater In other words, labor market must not clear --- labor supply must be greater than labor demand on the labor marketthan labor demand on the labor market



Labor

Labor supply

Labor demand

Efficiency wage

Market clearing wage

Wage

Unemployment



– Rents and efficiencyRents and efficiency

» Because workers are paid wage higher than market-clearing rate, they Because workers are paid wage higher than market-clearing rate, they earn rentsearn rents

» It is the rents they earn provide incentives for workers to performIt is the rents they earn provide incentives for workers to perform


Moral Hazard in Team Moral Hazard in Team

– Group performance measure and free ridingGroup performance measure and free riding

» A different kind of difficulty in motivation arises when a group of A different kind of difficulty in motivation arises when a group of people work as a teampeople work as a team

» In such a teamwork environment, individual members tend to free In such a teamwork environment, individual members tend to free ride on other members’ effortsride on other members’ efforts

» Furthermore, in teamwork, it is often the case that the team Furthermore, in teamwork, it is often the case that the team performance is available but the performance measures of individual performance is available but the performance measures of individual members are not available members are not available


Moral Hazard in Team Moral Hazard in Team

– Incentive contract in teamworkIncentive contract in teamwork

» Incentive contracts in this case serve the purpose of combating free Incentive contracts in this case serve the purpose of combating free ridingriding

» Economic analysis finds that if an incentive contract always Economic analysis finds that if an incentive contract always distributes returns among team members, such a contract will not distributes returns among team members, such a contract will not overcome free-ridingovercome free-riding

» In a team work setting, an incentive contract works only if the entire In a team work setting, an incentive contract works only if the entire group will lose a part of the return when performance isgroup will lose a part of the return when performance is

Dynamic IncentivesDynamic Incentives

Opportunism and Rents in FutureOpportunism and Rents in Future

– Another way to control moral hazard is to offer rents in the future, while the Another way to control moral hazard is to offer rents in the future, while the offering will depend on the current performance offering will depend on the current performance

– Example 1: Bonding Example 1: Bonding

» Agents may post a bond that they will lose if their performance falls short Agents may post a bond that they will lose if their performance falls short of targetof target

» Application in financial contracting: collateral and seniority in financial Application in financial contracting: collateral and seniority in financial claims claims

– Example 2: Seniority Pay and Career ConcernExample 2: Seniority Pay and Career Concern

» Agents expect pay higher than market rate later in the employment tenureAgents expect pay higher than market rate later in the employment tenure


Opportunism and Rents in FutureOpportunism and Rents in Future

– Example 2: Seniority Pay and Career ConcernExample 2: Seniority Pay and Career Concern

Seniority-based pay

Market wage

Employment tenure


Impediments in Formal Contract EnforcementImpediments in Formal Contract Enforcement

– Formal contract enforcement requires contracting to be explicitFormal contract enforcement requires contracting to be explicit» But detailed contracting may be too costly;But detailed contracting may be too costly;» Some specifics involved in transactions may not be enforced;Some specifics involved in transactions may not be enforced;» Sometimes subjective measurement has to be included in a contract;Sometimes subjective measurement has to be included in a contract;» And other times transactions rely on mutual understanding And other times transactions rely on mutual understanding

– Formal contract enforcement depends on well-functioning legal systemFormal contract enforcement depends on well-functioning legal system» Legal system generically applied, not tailored to specific situationsLegal system generically applied, not tailored to specific situations» Legal system is often cumbersome, time consuming, and expensiveLegal system is often cumbersome, time consuming, and expensive» Legal rules tend to be based on historical precedents, and hence unresponsive Legal rules tend to be based on historical precedents, and hence unresponsive

to changesto changes» Judges and juries may lack expertise and may be corrupted Judges and juries may lack expertise and may be corrupted


Reputation and Informal Contract EnforcementReputation and Informal Contract Enforcement

– The working environment of reputation mechanismThe working environment of reputation mechanism

» Parties’ behaviors cannot be legally contracted, but parties Parties’ behaviors cannot be legally contracted, but parties themselvesthemselves have enough information to evaluate each other’s past behaviorhave enough information to evaluate each other’s past behavior

» Repeated transactions between the partiesRepeated transactions between the parties


Reputation and Informal Contract Enforcement Reputation and Informal Contract Enforcement

– The functioning of reputation mechanismThe functioning of reputation mechanism

» Parties’ behaviors in a particular transaction can be classified into Parties’ behaviors in a particular transaction can be classified into three categories:three categories:

cooperation (trust is offered and honored), cooperation (trust is offered and honored),

unilateral defection (trust is offered but not honored), and unilateral defection (trust is offered but not honored), and

non-cooperation (trust not offered)non-cooperation (trust not offered)

» There are gains (rents) in cooperation (as compared to no-There are gains (rents) in cooperation (as compared to no-cooperation)cooperation)

» but also temptation to cheat but also temptation to cheat

» and loss to be cheatedand loss to be cheated



– The functioning of reputation mechanism: IllustrationThe functioning of reputation mechanism: Illustration

Trust offerorTrust offeror

Decision makerDecision maker TrustTrust Do not trust Do not trust

Honor trustHonor trust W, VW, V 0, 00, 0

Do not honorDo not honor

Unilateral defection

-L, V + G 0, 0

Non-cooperation



– The functioning of reputation mechanism:The functioning of reputation mechanism:

» Without repetition of interactions between the offeror and the Without repetition of interactions between the offeror and the decision maker, the decision maker will not honor trust, and the decision maker, the decision maker will not honor trust, and the offeror will not offer trustofferor will not offer trust

» With repeated interactions, decision maker may find it in his own With repeated interactions, decision maker may find it in his own interest to honor the trust, provided that interest to honor the trust, provided that the long term gain from the long term gain from cooperation exceeds the short term benefit from defectioncooperation exceeds the short term benefit from defection

» The long term gain from cooperation exceeds the short term benefit The long term gain from cooperation exceeds the short term benefit from defection,from defection, because cooperation leads to long term dealings while because cooperation leads to long term dealings while one-time cheating destroys trust and cuts short of these dealingsone-time cheating destroys trust and cuts short of these dealings



– Keys to reputation mechanismKeys to reputation mechanism

» There must be (frequent) future interactions; and There must be (frequent) future interactions; and

» There must be rents for future cooperation!There must be rents for future cooperation!

– ““End game” problem and some possible solutionsEnd game” problem and some possible solutions

» Golden handshake and retirement funds Golden handshake and retirement funds

» Sale of business Sale of business



– Reputation and third party sanctionsReputation and third party sanctions

» In many situations, a decision maker may have repeated dealings with In many situations, a decision maker may have repeated dealings with a group of trust offerors, but has only non-repeated or infrequent a group of trust offerors, but has only non-repeated or infrequent dealings with each one within the groupdealings with each one within the group

» Example: business and customers Example: business and customers

– Role of formal institutions in third party sanctionsRole of formal institutions in third party sanctions

» Information dissemination: credit rating and better business bureauInformation dissemination: credit rating and better business bureau

» Ambiguity, rules, principles and “informal laws” Ambiguity, rules, principles and “informal laws”

» Rumors and verification Rumors and verification


PromotionsPromotions

– Dual functions of promotions: Dual functions of promotions:

» Allocating talentsAllocating talents

» Providing incentives and rewardsProviding incentives and rewards

– Why promotions instead of hiring from outsideWhy promotions instead of hiring from outside

» Better talents are needed at higher level positions because these Better talents are needed at higher level positions because these positions usually have a larger impactpositions usually have a larger impact

» Internal promotions better collect information about talents than Internal promotions better collect information about talents than hiring from outsidehiring from outside

» For this very reason, promotions may also reveal information to For this very reason, promotions may also reveal information to outside labor market competition outside labor market competition



– The potential conflict in the dual functions of promotionsThe potential conflict in the dual functions of promotions

» A person performing well on the current position may not suit for the A person performing well on the current position may not suit for the job at a higher level positionjob at a higher level position

» Possible solution: multiple promotion tracks Possible solution: multiple promotion tracks



– Disadvantages of promotion incentives, as compared to monetary Disadvantages of promotion incentives, as compared to monetary incentivesincentives

» Promotions are discretePromotions are discrete

» Promotions rely on positions availability, thus infrequent Promotions rely on positions availability, thus infrequent

» Promotions create competitionPromotions create competition

» ““Peter Principle” Peter Principle”



– Advantages for promotions incentives, as compared to monetary Advantages for promotions incentives, as compared to monetary incentivesincentives

» Only relative performance measures availableOnly relative performance measures available

» Common elements to the uncertainty in performanceCommon elements to the uncertainty in performance

» Helps managers to commit to implementing incentives Helps managers to commit to implementing incentives



– Job-attached pay and promotions Job-attached pay and promotions

» Promotions are often linked to the fact that pay is attached to different Promotions are often linked to the fact that pay is attached to different jobsjobs

» A number of reasons for pay to be job-attachedA number of reasons for pay to be job-attached

» (1) performance is often difficult to be measured(1) performance is often difficult to be measured

» (2) performance is often evaluated in a decentralized fashion, job-(2) performance is often evaluated in a decentralized fashion, job-attached pay restricts managerial discretionattached pay restricts managerial discretion

» (3) together with promotion possibility, job-attached pay creates (3) together with promotion possibility, job-attached pay creates incentivesincentives



– Promotions, efficiency wage and internal labor marketsPromotions, efficiency wage and internal labor markets

» In reality, firms typically implement internal labor-market systems In reality, firms typically implement internal labor-market systems that share the following features: that share the following features:

» Workers are mostly hired in at the entry levelWorkers are mostly hired in at the entry level

» Pay is attached to jobs with various performance standardsPay is attached to jobs with various performance standards

» Good performers on the job are promoted in rank as well as in payGood performers on the job are promoted in rank as well as in pay

» Bad performers on the job are dismissedBad performers on the job are dismissed

» Such systems serve two purposes: (1) to sort various talents into Such systems serve two purposes: (1) to sort various talents into different positions, and (2) to provide incentives through long-term different positions, and (2) to provide incentives through long-term career concerns along with rents from efficiency wage career concerns along with rents from efficiency wage

Bo Com Lectures

Business

Transcript of Bo Com Lectures