2 Incentive Conflicts and Contracts

Question 1

What are Owner‐manager conflicts?

Answer 1

• Large corporations usually delegate decision authority to top executives
• Different conflict of interests can arise:

1. Effort choice
2. Salaries, bonuses, and perquisites
3. Risk taking behavior
4. Time horizons
5. Overinvestment (empire‐building)

Question 2

How does signalling as a solution to adverse selection work?

Answer 2

Signaling:

Individuals can

• try to signal their private information in a credible fashion. (E.g., in example I, Angela might regularly participate in running contests and can document that, while this is relatively more costly for Bruno and Cindy.)

-> but again: costly.

Question 3

What are examples for asymmetric information?

Answer 3

• Example 1: Contract between health insurance company and new client: the health insurance company is at an informational disadvantage since it does not know the complete health history of the client and of the client’s family (genetic dispositions for certain diseases)
• Example 2: Managers in a company may have insight knowledge on which projects are most profitable for the company that shareholders do not have
• Example 3: Real-estate agent should sell house for you at highest price, but only s/he knows whether s/he tried her best

Question 4

Is it worthwhile for shareholders to seek to completely eliminate incentive problems with managers and directors through means such as monitoring? Why or why not?

Answer 4

• Generally speaking, it is not worth the costs to completely eradicate incentive problems.
• It is optimal to incur expenses to reduce agency problems only up to the point where:

the marginal reduction in the residual loss = the marginal increase in the expenses to deal with them.

Question 5

What is residual loss?

Answer 5

Residual loss = loss in gains from trade that results from the divergence of interests within the principal‐agent relationship.

Question 6

Is this an adverse-selection problem or a moral-hazard problem? Explain why. Name and explain one way in which the restaurant manager can address this problem. A restaurant owner hires a manager who promises to work long hours. When the owner is out of town, the manager goes home early. This action results in lost profits for the firm.

Answer 6

Moral-hazard - post-contractual information problem: The manager initially promises to work hard but ends up closing the restaurant early when the owner does not supervise the manager.

Possible solutions:

• Give the manager a monetary incentive to leave the restaurant open: profit sharing plan.
• Set up alternative monitoring technology / arrangement (e.g. other person who has a financial interest in keeping the restaurant open late supervises the manager when the owner is out of town).

Question 7

What are Precontractual information problems?

Answer 7

informational asymmetries that arise before the contract is signed

• Negotiating a labor contract
• Negotiating with a supplier
• Consequence (but also used as synonym): adverse selection

Question 8

Discuss the incentive conflicts that are likely to arise between owners and managers of a restaurant.

Answer 8

Question 9

What are examples of agency relationships within firms?

Answer 9

• shareholders – board of (outside) directors (oversee management)
• board – senior executives (operating decisions)
• senior executives – lower level employees (e.g., production tasks)

Question 10

How does screening as a solution to adverse selection work?

Answer 10

Insurance company can

• Collect information to become better informed and then apply customized rates; but: costly (e.g., collecting and assessing medical exams from applicants)
• Offer a menu of contracts (e.g., different deductibles, prices) -> selfselection of individuals

Question 11

What are examples of incentive conflicts between shareholders and managers?

Answer 11

• manager may prefer to invest in his/her personal “pet project” rather than alternative projects that would maximize shareholder value
• managers may spend company resources for personal consumption
• manager may shirk on components of his/her job that are beneficial to the company and to shareholders but are hard to verify (e.g. provide guidance on professional development or mentorship)

Question 12

What are Postcontractual information problems?

Answer 12

informational asymmetries that arise after the contract is signed

• Within firms:
managers/employees have private information about how hard they work

• Between firms:
Supplier is better informed about the relationship‐specific investments

• Consequence (but also used as synonym):
moral hazard

Question 13

What is Agency relationship (or principal‐agent problem) and what problems typically occur?

Answer 13

• One party (principal) engages another party (agent) to perform some task or service.

• Diverging interests between principal and agent
-> contracts can help align interests

• Asymmetric information
-> frequently precludes the costless and perfect alignment of interests

Question 14

What are examples of agency relationships between firms?

Answer 14

• firm – supplier (production of intermediate good)
• firm – law firm (legal advice)

Question 15

What kind of firm ownership are there?

Answer 15

• sole proprietorships = business entity owned and run by one natural person -> this person is the residual claimant
• partnerships -> partners are the residual claimants
• large public corporations -> thousands of shareholders are the residual claimants

Question 16

What is asymmetric information? How can it limit contracts from solving incentive conflicts?

Answer 16

Asymmetric information means that not all contracting parties share the same information.

Question 17

The Sonjan company, based in the U.S., currently purchases health insurance for all of its 1,000 employees. The company is considering adopting a flexible plan whereby employees either can have $2,000 in cash or purchase an insurance policy (which currently costs $1,000). Do you see any potential problems with this new health insurance plan? Explain.

Answer 17

• New plan is more costly for the company whenever an employee opts for the cash $2,000 > $1,000
• New plan has larger administrative costs (e.g. information and record-keeping of choices)
• Employees can freely choose between taking the money or the insurance à adverse selection problem
• People who are least healthy are most likely to opt for the insurance (e.g. people with expected health related expenses > $2,000)
• Insurance firm may react to this by increasing the price for the insurance policy (new insurance price > $1,000) since the pool of insured employees under a flexible plan is “less healthy” than the pool of insured employees under a mandatory company-wide plan

Question 18

Is it worthwhile for shareholders to seek to completely eliminate incentive problems such as employees take home stationary from the office? Why or why not?

Answer 18

• Solution 1: put office supplies in location that is highly frequented during business hours (mutual monitoring of employees) and keep record of employee’s stationary consumption.
• Solution 2 (definitely too costly): complete search of all employees who leave the building every time that they exit the building

Question 19

What is the definition of the firm owners?

Answer 19

Firm owners = residual claimants (i.e., they get what is left over after all other claimants are paid)
-> want to maximize the present value of residual profits

Question 20

What are Agency costs?

Answer 20

Agency costs = residual loss + contracting costs (e.g., monitoring, performance measurement, legal fees…)

Question 21

What are examples of incentive conflicts within workers and teams?

Answer 21

• most prominent incentive problem: free rider problem: arises when only total group output is observable but not what each team member contributed to it; individual team members have an incentive to shirk and let other team workers work hard
• Promotions (e.g. relative performance evaluations) and collaboration: when only the best performers are promoted, coworkers in teams can have an incentive to sabotage each other or not help each other to perform better at work

Question 22

Is this an adverse-selection problem or a moral-hazard problem? Explain why. Name and explain one way in which the restaurant manager can address this problem.

A restaurant decides to offer an all-you-can-eat buffet that is sold for a fixed price. The restaurant discovers that the customers for this buffet are not its usual clientele. Instead, the customers tend to have big appetites. The restaurant loses money on the buffet.

Answer 22

• Adverse selection
• Precontractual information problem: people who see the price of the buffet know how much they are likely to eat but the restaurant does not.
• Only people who eat “sufficiently much” and more will be willing to pay the fixed price for the buffet

Possible solution (of many): increase the price of the buffet such that it covers the cost for the customers with the most appetite; offer deals to other customers (e.g. fill a smaller plate for a lower price)

Question 23

What does “The Firm as a Nexus of Contracts” mean?

Answer 23

Decision‐making processes within firms are complex.

• Many decision makers
• Objectives of firm owners and decision makers usually differ

-> The firm can be seen as a focal point for a set of contracts. The firm is one of the parties to each of the many contracts that constitute the firm.

Question 24

What are potential ways to address the problem of adverse selection?

Answer 24

• Screening
• Signaling

Question 25

How can asymmetric information limit contracts from solving incentive conflicts?

Answer 25

1) With symmetric and verifiable information incentive conflicts would be relatively easy to solve: contracting parties agree to take certain actions and if they do not, there is some form of penalty (e.g. a fine) 2) Asymmetric information can make it difficult for all parties to assess whether or not a contracting party has honored the terms of the contract. 3) measures to reveal information are costly (e.g. health insurance company) 4) under asymmetric information, providing incentives to contracting parties lead to additional costs

Question 26

In a signalling game for firms (hoping to attract particularly talented applicants by offering increased wages for employees holding a master’s degree), which conditions need to hold in order for the firm's plan to work out?

Answer 26

* positive correlation between high degree choice and high job productivity (= *applicants with a master's degree tend to be more productive*): 𝛿 E[a | s] / 𝛿 s ≥ 0 * negative correlation between job productivity and effort costs of obtaining a master's degree (=*more productive applicants tend to find it easier to complete a master's*) 𝛿c(a) / 𝛿a ≥ 0, cₕ ≤ cₗ

Question 27

In a signalling game for firms (hoping to attract particularly talented applicants by offering increased wages for employees holding a master’s degree), which specifications constitute an equilibrium?

Answer 27

* the degree choices of each "type of applicant": s\*(aₕ), s\*(aₗ) * the firm's wage offers conditional on the education level: w\*(s=0), w\*(s=1) * the firm's beliefs given the degree choice of the applicants: * q\*(aₕ | s=1) = Prob\*(aₕ=a | s=1) * q\*(aₕ | s=0) = Prob\*(aₕ=a | s=0)

Question 28

Which types of equilibria are there in signalling games?

Answer 28

* pooling equilibrium * separating equilibrium

Question 29

What is a pooling equilibrium?

Answer 29

Both types choose the same signal

Question 30

What is a separating equilibrium?

Answer 30

Each type always sends a specific signal

Question 31

How do firms choose the wages in a market of applicants? How does this play out when there are lower/higher ability applicants?

Answer 31

firms compete for applicants and therefore make zero profits -\> **wages are calculated by setting profits equal to zero** With different types of applicants, this means that the **wage is the expected productivity** of these applicants (e.i. sum of applicant productivity \* probability of type)

Question 32

In a **signalling game** for firms (hoping to attract particularly talented applicants by offering increased wages for employees holding a master’s degree), what are the **equilibrium wages for different types** of applicants in a **separating equilibrium**?

Answer 32

As firms know the types of the applicants in a separating equilibrium and make zero profits, each applicant will get the exact wage of their productivity.

Question 33

In a **signalling game** for firms (hoping to attract particularly talented applicants by offering increased wages for employees holding a master’s degree), what are the **conditions/requirements for a separating equilibrium** to exist?

Answer 33

the so-called "no mimicking constraints" (=special form of incentive constraints): * *each type must prefer to reveal their type over pretending to be the other type*

Question 34

What do you need to check if you want to know whether a signalling game still works with a different utility function?

Answer 34

If any of the conditions/assumptions about the types in relation to each other has changed (e.g. are the costs of one type still larger than the costs of the other type?)

Question 35

In a **signalling game** for firms (hoping to attract particularly talented applicants by offering increased wages for employees holding a master’s degree), **what is the social (i.e. overall) efficiency of education** according to this model?

Answer 35

* Education serves the sole purpose to signal ability to future employers (asymmetric information about ability between applicants and firms) * The education choice can overcome this information problem: in a separating equilibrium, education perfectly reveals her ability type to the firm * Education does not increase productivity; the effort put into obtaining a master´s degree does not create any other value than potentially higher wages. * Under perfect information applicants would not need to “waste their time” on a master´s degree. Also check whether pooling or separating equilibrium is more efficient and who is better off in which!