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TOPIC 3: INCENTIVE CONFLICTS AND CONTRACTS
1- OVERVIEW
In the last topic we studied how transaction costs affected broad patterns of economic organization. Now we look more specifically at the contractual strategies that people adopt to control opportunistic behavior. We will provide much more detail about why motivation problems arise, and what might be effective responses in each case
2- CONFLICT, INFORMATION AND CONTRACTS
In a firm there are many relationships, so there are also many conflicts with them ( diverging goals ):
• The firm wants the worker to work, but the worker wants to be lazy
• Shareholders want short-term returns, but the firm wants long-term returns
• The firm wants suppliers to supply high-quality inputs, but the suppliers want to
save money and provide low-quality inputs.
The Tension: it is in everyone’s interests to come together and form organizations that support specialization and trade. But once they have established these organizations, they are incentives to misbehave. So, parties must safeguard themselves against the bad behavior of others before they enter into relationships with them.
Example: you value a good plumbing job at 40, and a bad plumbing job at -10. it costs a plumber 20 to do a good plumbing job, and 10 to do a bad plumbing job. If you don’t hire the plumber, you both get 0. is trade efficient in this setting? Is trade possible without safeguarding? No trade Good job Bad job
You 0 40 -
Plumber 0 20 10
Surplus 0 40-20=20 -10-10=-
Suppose I pay a plumber 25€ to come to do the job. My net payoff is the 15, it’s 5 if he comes and does good job.
A contract is a voluntary agreement to organize a transaction. The timeline is the following:
.1 Parties acquire characteristics: if you do a good job I will pay you, if not, I don’t.
Determine what good job / bad job means.
.2 parties design contract
.3 parties take actions
.4 results of the actions are realized
.5 payments are made
There exist two types: An explicit contract specifies verbally or in writing what each party’s obligations are. (this topic) An implicit contract is a set of expectations that each party has about others’ behavior. (topic 5)
Enforcement: an implicit assumption in the economics of contracts is that they are enforced. In reality, this is not so clear:
• Some countries’ legal systems are inefficient/corrupt
• Going to court is very costly
If contracts are not easily enforceable, then they will not provide effective safeguards.
CONTRACTING WITH LIMITED INFORMATION:
We will characterize contracting situations according to information problems. If everybody can observe everything about everybody else at all times, then achieving efficient outcomes is easy. What contract would deliver an efficient outcome in the plumber example? Is this contract realistic?
One with all the information attached. It is not realistic, we don’t have enough information. We can’t predict the future. In reality, people contract without full information about each other, or about the economic environment. The problems arrive when people don’t know the kind of person they are trading with.
In markets that change frequently, it’s difficult to describe all future possibilities; therefore it is also difficult to describe the actions that each party should take. Suppose you contract a computer supplier for the next five years: how could you describe what products you want delivered?
The core of this topic deals with environments in which one party knows something that the other does not. In particular we focus on two situations:
• Before writing the contract, one party does not know something about the other’s
characteristics.
• After writing the contract, one party does not know what action the other took.
3- PRE-CONTRACTUAL INFORMATION PROBLEMS
3-..1 Parties acquire characteristics:
3-..1..i What you like
3-..1..ii How smart you are
3-..1..iii How much money you make
3-..2 parties design contract
3-..3 parties take actions
3-..4 results of the actions are realized
3-..5 payments are made
ISSUES:
1- Bargaining:
It is clear that trade should happen when a seller of a good values it less than a buyer: (Vs <=p<=Vb) If Vb > Vs F 0 E 0inefficient trade If Vb < Vs F 0 E 0good trade If both people know each other’s valuations, they should be able to agree a price at which to trade the good. I they do not know these valuations, then trade might not happen, which is inefficient.
Example: My house is worth 50.000 to me. You may value my house at 100.000 or 500. but don’t observe this. I believe each valuation is equally likely, if I can choose jus one price, what should it be? Vs = 50. Vb1 = 100.000 F 0 E 0payoff is 100. Vb2 = 500.000 F 0 E 0payoff is 250.000 (0.5*500.000) The problem with 500.000 is that there is only one person available to pay this amount. If he leaves, all is over. This price is inefficient.
2- Adverse selection:
In many markets there are “bad types” with whom people don’t want to trede. Unfortunately, these types may be exactly the ones that are attracted to trade. This may prevent trade with good types.
In some situations, bad types are more likely to participate in the trade than good types (car insurance). Maybe people who wants to trade isn’t the same the people actually do.
Example: insurance market. To whom do companies want to sell insurance? Those who don’t suffer incidents (good types). Who wants to buy insurance? Those who may have an incident (bad types)
DRIVER EXPECTED LOSS
What has the teacher (teacher – upf students) do to only trade with good types?
1- Put 8am classes: people who show up are good types.
2- Increasing wage profiles in firms. People who hold on are good types. Force to stay
to get a huge wage. If not, they would be antering and getting out.
All solutions end up creating costs to sustain trade. These costs are part of the transaction costs of sustaining trade with good types. Some might appear wasteful, but without them we sould have not trade at all. Depending on the situation, incurring waste and trading may or may not be better than simply not trading.
4- POST CONTRACTUAL INFORMATION PROBLEMS
3-..6 Parties acquire characteristics: if you do a good job I will pay you, if not, I
don’t. Determine what good job / bad job means.
3-..7 Parties design contract
3-..8 Parties take actions
3-..8..i hours worked
3-..8..ii type of material used in production
3-..8..iii type of investments made
3-..9 Results of the actions are realized
3-..10 Payments are made
3-..10.-1 Principal-Agent model and moral hazard
Principal: I want something done Agent: person who actually takes the action. The principal engages the agent to perform some service on the principal’s behalf. But the agent might take opportunistic actions that harm the principal: moral hazard.
The term moral hazard (like adverse selection) originated in the insurance literature. Suppose you rent a car and are provided full insurance for accidental damage. How will you tend to drive the car?
3-..10.-2 Performance pay as a solution
A popular solution to the moral hazard problem is to link the agents’ pay to observable results (why not link pay to actions?). We want to pay the agent more when results indicate he acted in the principals’ interests, and less whan he didn’t. In the insurance example, we can force the driver to pay out some of the cost of accidents.
1. Parties acquire characteristics: if you do a good job I will pay you, if not, I don’t.
Determine what good job / bad job means.
2. Parties design contract (formula linking 4. and 5. is agreed)
3. Parties take actions
4. Results of the actions are realized
5. Payments are made (these depends on 4.)
CEO Pay: CEOs are in agency relationship with the Board of Directors and shareholders. What are the shareholder’s interests? How can they link CEO pay to their interests?
Application to “El Enchufe”: Cultures in which rewards accure to those who know the right people provide less work incentives than others. One can translate this argument in terms of our basic principal agent model:
• Suppose working hard costs 10 and being lazy costs 0
• Suppose getting a good job is worth 100 and getting a bad job is worth 30
• Suppose the probability of getting a good job after working hard is 0.9, and after being
lazy is 0.1…would you work hard?
• What if these probabilities were 0.9 and 0.8?
PROBLEMS WITH PERFORMANCE PAY:
• Risk: exposes the agent to risk
Performance usually has some random component the agent doesn’t control. This introduces risk for the agent that makes him less willing to contract with the principal.
EX: you can damage your rental car because of a rock on the highway F 0 E 0not your fault but you still pay F 0 E 0you might hesitate to rent the car if you don’t like risk
• Multi-tasking (not in textbook or exam)
In many situations workers choose among several different tasks with different results. Some of these produce a measureable output while other don’t. Paying on the basis of good performance in the measurable task increases effort on that task…but potentially decreases it on the non-measurable task! Some generate results, others not, but all are important. If you pay for one task, people will forget about the other.
EX: sports contracts: There is lots of available information about individual players’ performance on a football team, e.g. goals. Why don’t football players earning huge bonuses per goal? Because they’d forget about all other staff, also important.
-1 Monitoring and bonding costs + residual loss.
Monitoring and bounding costs reduce the incidence of opportunism. Monitoring costs: efforts made by the principal to observe and reward performance. Again, we must be mindful of the cost! EX: In 2008, companies spent around $13.5 billion on software to monitor employees (videos, email monitors, key stroke trackers)
Bonding costs: as agents tend to misbehave they assume this cost. Is the money spent by the agent in resources to safeguard the relationship. Agent pays money ex-ante to commit to not misbehave ex-post. Convince that they are going to pay. Ex: To rent my flat in Barcelona, I had to deposit thousands of Euros F 0 E 0lose interest payments but get to rent
Residual loss: any remaining loss due to opportunism. The difference between the maximum possible surplus (achieved without moral hazard) in relationships and the actual surplus achieved with opportunism.
Agency costs = safeguard costs + residual loss
Safeguard costs = monitoring costs + bonding costs
5- ACCOUNTING FOR CONTRACTING COSTS
Painter example:
