FINAL EXAM

Part A: 20 MC questions (40 marks)

Part B: 3 Short answers (40 marks)
All of the topics covered
Important topic:
Property right model, hold up, ownership
Signalling (education)
Moral hazard in teams
Incentive (principal-agency model)
Double marginalisation problem
The final exam will cover all material studied in the unit (lectures, tutes, readings etc).
Important topics include: incentives; the signalling model; the double-marginalisation model; moral-
hazard in teams; and the property-rights (ownership) model.


2 objectives of compensation policy: (1) attract & retain qualifies employees; (2) motivate
employees to be more productive
Contracting objective: Owners want to design compensation package that attracts and retains
employees with required skills at lowest possible cost
Level of pay: Basic competitive model
- labour market competitive (firms price takers)
- market wage rates costless observable
- individuals are identical in their training and skills
- all jobs are identical (risk, location, etc)
- no long term contracts
- all compensation $ compensation (ie no fringe benefits)
Signalling model: Workers signal their productivity by getting an education
More productive workers have a lower disutility of education
high types need to get enough education to make it not profitable for low types to pretend that
they are of high type; high types get just enough education that it would not be worthwhile for a low
type to also get that much education
In equilibrium, high productive worker get enough education so low productive worker do not copy
them.
Credible signalling is costly
Employers competitive, therefore wage must equal expected MRP In Final exam
Equilibrium
1. workers of type i must be maximising utility
2. Firms must be making zero expected profits
3. Beliefs must be consistent with outcome ie what a firm believes about education and worker type
must coincide with the final outcome
In final exam: MC
Separate equilibrium: low type do one thing, high type do other thing, do not want low type pretend
to be high type
Model of signalling
type L has productivity 0; type H has productivity 1
Low type come to work better than not work: wL 3eL 0 (1) participation constrain; individual
rationality constrain (IR constrain)
Low type need to better off doing low type work wL 3eL wH 3eH (2) incentive capability (IC
constrain)

High type come to work better than not work: wH eH 0 (3) participation constrain; individual
rationality constrain
High type need to better off doing high type work wH eH wL eL (4) incentive capability (IC
constrain)
wL* = 0 wH* = 1
from (1) 0 3eL 0 eL <=0 eL* = 0
from (2) 0 0 1 3eH 1 - 3eH eH* 1/3
Check (3) 1 1/3 0
Check (4) 1 1/3 0 0
Beliefs:
Firm believes: e < 1/3 type L with prob = 1 e 1/3 type H with prob = 0
Outcome: Equilibrium type Ls get eL* = 0 type Hs get eH* = 1/3
wL* = 0 if e < 1/3 wH* = 1 if e 1/3
Beliefs: if e < 1/3, prob type L = 1 if e 1/3, prob type H = 1

Indifference curve of low type worker is steeper than high type worker
Boundary

Human capital (general v specific)
- Human capital set of skills of a worker
- value of human capital determined in market place
- - return of investment (higher wages etc)
General human capital equally useful to a broad array of firms
Specific human capital valuable to one employer, but not to alternative employer (ie. learning
specific firms system, etc)
From basic competitive model
Firms would not invest in general human capital/training because employees would take training
and go to another firm
Employees will not invest in specific investments as does not increase market values
Reason: Employees capture the gains from general training. An employee with increased general
skills/training will have her salary bid up by other firms.
In contrast, the gains from specific training go to the firm. If the employee pays for this training there
will be no market pressure to increase his salary to compensate him for the training costs incurred.
Through use long term contract: -internal labour market can provide a method for long-term
relationshop that promotes development and use of firm-specific capital (employee wont be able to
bid up the wage to equal outise option and the for the firm the wage wont instantly have to equal
the MRP of the worker)
Compensating differentials
- paid more for unpleasant conditions; - paid less for pleasant conditions
1st compensating differentials attract people to these jobs and reward them for their efforts.
Individuals who do these jobs are the ones who tend to have the lowest cost of doing themself
select (least disutility from noise etc)
2nd compensating differentials mean unpleasant work environments have higher labour costs
(other things equal)
Costly information about market wage rates:
- difficult to observe wage rates - imply rate from actions of employees/potential employees
Efficiency wages:
- difficult to monitor employee actions
- difficult to devise incentive schemes
- difficult to encourage quality over quantity etc

One way to motivate employees is to pay above the market rate of compensation
- increases labour costs, but decreases incentive to shirk ,
- if a worker cheats and is caught, they lose their wage premium
- this effect will be greater when employees have a longer time frame
Empirically, lower turnover and industry wage differentials, other things equal
Job seniority , and pay
- Generally pay increases with tenure - but sometimes pay increases more than MRP
- Incentive for employees to work in interests of firm
- Young want to stay and get bonuses later - old want to stay as $ > outside opportunities
- given that w > MRP for the old, why not sack old workers?
Promotions: employees compete for promotions and higher pay; contest/tournament among emplo
why firms often have mandatory retirement? (where allowed by law)
Firms with internal labour markets can pay below the MRP at the beginning of an employees tenure
and pay more than the employees MRP later in the tenure cycle as a means of providing incentives.
To remain competitive, a firm cannot continue to pay a salary greater than MRP forever (or for too
long), hence it needs a time limit on these payments. Mandatory retirement provides this limit it
also saves credibility problems by sacking/removing older workers in a seemingly ad hoc manner.


Influence costs: activities employee care about but employer does not care, agent wants to influence
decision in favour, principle wants to elimination influence costs
- limit pay sometimes to limit contention about pay differences
- Bureaucratic rules characterise jobs, then pay those jobs in a certain band of pay (ie $20K-$25K)
- Reduce complaints - increase incentive to boost supervisor roles

Fringe benefits salary mix
Appropriate mix: depends on employee preference & cost of supplying wages and fringe benefits
(choose w* and FB* to min cost of providing compensation that gives worker welfare U0)
- employers can use mix to attract types of workers if preferences for Fringe benefits wages related
to other characteristics (ability to work late, w/e etc)

Wage$

w*
UR reservation utility
BC
FB* FB$

Why do firms form internal labour markets?
(i) promote investment in firm-specific human capital
(ii) long-term relationship gives extra flexibility when designing pay packages to give incentives
(iii) allows a firm to obtain information about to improve matching

Incentive compensation
Basic problem: - different objectives - need to motivate employees
If effort is observable and can be contracted on (verifiable and enforceable) - compensation
package: pay $X if put effort e* - could induce more effort, but beyond MB=MC profits fall
E.g. Unobservable effort:
Agent: utility=income effort^2 UR reservation utility=1000 (outside option)
Principal: benefit=100e profit=benefit-wage
Observable effort:
UR=1000=Income - effort^2 income = 1000+effort^2
Profit=benefit wage =100e-(1000+effort^2)
Derive e to maximize profit: 100-2e=0 e*=50 MB=MC
Wage = 1000+ 50^2 = 2500
If effort is unobservable: No contract specifies e* that is enforceable
Ownership as an incentive device: - employee becomes the residual claimant
- ownership provides incentive to put in desired effort (also franchising, providing incentive to max
surplus)
Sell firm / operation to agent for $1500
Firm get profit=1500
Agent get: utility=income- e^2 =100e-1500-e^2
Derive e: 100-2e=0 e**=50 Agent get full MB, Agent bears full MC; agent get full return of
their effort Agent has firstbest incentive.
Why not always used? - wealth constraints - risk aversion; as output is random to some extent,
selling the firm means employee bears the full risk. Most employees risk averse; risk aversion limits
scope to sell firm completely to employees - team production (free rider problems)

Optimal risk sharing: Agent that are risk averse
Two people, each person ace get $0 or $10000 with prob
Expected income for each person= (0) + (10000) = 5000 U(EI)=U(5000)
Expected utility: U(0)+ U(10000)
Risk neutral: Expect Utility =U (Expect Income)
Risk averse: Expect Utility < U (Expect Income) Concave utility curve e.g. U=w^1/2
Risk lover: Expect Utility > U (Expect Income)
If both parties are risk averse, pool income and both better off; Expected income unchanged, but
less risky.
Risk averse person more likely to give up expected income in order to not face risk get zero.
Trading opportunity: risk neutral person take risk and pay risk averse person less income;
-reduce risk faced by risk averse agent
-Principle: surplus increased when risk is borne by the risk-neutral party (not the risk-averse party)
Deal: risk neutral person get risk averse persons income and pay risk averse person 4500
Risk averse: U(4500)
Risk neutral: U(0-4500) + U (10000-4500)+ U(20000-4500)
Effective incentive contracts: 2 complications: (1) motivating employees (2) share risks more
efficiently - there is a trade-off between providing incentives and risk sharing
A compensation package must balance the two considerations:
- risk sharing suggests fixed wage salaries for employees (firms bearing all the risk)
- best contract consists of fixed component and variable component based on performance
In an incentive contract
- changes in the fixed component does not change the effort level of the agent
- changes in marginal return from effort (incentive coefficient) increase effort
Output is observable, but effort is unobservable, can put Q in contract, but cannot put e in contract
Principal: risk neutral Agent: risk averse -Optimal risk sharing would have principal take all risks

2 Graph on lecture 6 18~21
The optimal contract: - firms problem to choose compensation scheme that max expected profits
given agents anticipated effort level - incentive coefficient affects effort level
- fixed component can be adjusted in order to satisfy reservation utility
Note a higher incentive coefficient imposes a cost on the principal: requiring more effort requires
Agent must get paid more; increasing risk Agent faces also increases the pay Agent requires

In general, - would not get surplus maximising outcome; -do not get optimal risk sharing;
- do not get surplus max level of efforts

Implications: - often contract involves lower effort that if effort could be observed without cost
- cost of imposing risk on employee means higher wage cost for the firm

Factors favouring high incentive pay:
1. value of output sensitive to employees effort
2. employee is not risk averse
3. level of external uncertainty low
4. employee responds to incentives
5. output can be measured easily

Basic Principle: Informativeness Principle
In designing incentive contracts, productive to include all performance indicators that provide
additional information about effort (assuming low measurement costs). Increasing precision
reduces cost of inefficient risk bearing and leads to a more efficient effort choice
- provided a signal provides new information, beneficial to use it in the incentive contract ?
- relative performance can be a good indicator (removes external shock)
- also spend resource on improving measurement of effort

Incentive compensation and information revelation: asymmetric information between effort and
general condition; information is valuable
- central office uncertain about quality or potential of regional sales, want regional manager to
reveal information - problem: setting information revelation into incentive contract
Does incentive pay work? - why are incentives not used?- too effective?
Balance of effort or Manipulation
Group incentive pay: - easier to measure - may encourage team work - motivate employees to
monitor each other *free rider problem
Multiple P-A problem: incentive between tasks are complementary
- many tasks - need to motivate employee to strike balance between tasks
- some tasks can be monitored easily(e.g. sales), others not(flat or no incentive e.g. service)

Executive compensation: - need to motivate CEOs and other managers
- Holden (2005): Need to get the incentive system correct, otherwise get perverse outcomes
- Bebchuk & Fried (2003)
Optimal contracting idea: executive compensation designed to alleviate agency problem
- suggests that executive compensation is part of the agency problem - that is, the level and the
type of compensation arises not to help alleviate the incentive problem, but because executives
have incentives to rent seek at the expense of shareholder value
Optimal contracting result of arms length bargaining between the board and CEO
- no reason to assume directors will seek to maximise shareholder value

1.Directors elected by slate, so director slate proposed by manager is the only one proposed -
directors likely to accept management compensation package
2.Directors have only nominal equity in company
3.Market for corporate control some pressure - but takeover premiums can be large
- also CEO of firms with strong takeover protection (such as supermajority rule) get pay
packages that are both larger and less sensitive to performance (adoption increases pay from an
already high base)
4.Negative media coverage - outrag , but response is to camouflage rent extraction
- increase in substantial option pay, without corresponding amount of cash compensation

Compensation consultants: -used to justify CEO pay
- advocate relative performance when it suits & comparable compensation for underperformers
- consultants want to be rehired


Gratuitous goodbye payments - even when company underperforming
-relate to optimal agency contracting: Suggestive of managements influence over the board
Optimal contracting: -no link to management performance -no use of relative performance
measures

Managerial power higher/less sensitive to performance in firms in which managers have relatively
more power
(1) the board is relatively weak
(2) no large outside shareholder
(3) fewer institutional shareholders
(4) managers are protected by anti-takeover arrangements

Individual Performance Evaluation - compensation and performance evaluation linked

Assume: P knows output function, can observe output, but not effort; output only measure of
performance; employee produces single output; employee works independently (no team), any
mutually beneficial contract feasible.

Benchmarking: how do firms set standard for average worker?
- estimated (a) time and motion studies; (b) past performance
Ratchet effect : Worker try to not performance best in order to reduce past performance
and have easy performance in future; passive and no responsibility.
How to avoid? Committed not change scheme for a long time, piece rate that does not
change frequent job rotation (loss of specific Human Capital, knowledge)

Measurement costs:
Output observable two transacting parties can observe output/variable of interest
Verifiable/contractible output can be verified by an outside party (court)
- output is a coarse measure of employee effort(output signal of effort)
Better measure employee effortreduce employee exposure to risk reduce wage premium
Other things equal, the more incentive pay in employees package, the more risk an employee bears
and the more the firm should spend on measurement systemsOutput should more direct or
accurate measure effort
- optimal level of incentive compensation and measurement jointly determined
Some measures look at one aspect of output
- value of measure depends on correlation to underlying output measure
Opportunism
Gaming performance evaluation can create perverse behaviour: horizon problem
Time horizons are different between shareholder and agent, long-run and short-run decisions
Solution: use both long-run and short-run incentive scheme in contract e.g. cannot sell stock in 5 years
Relative performance evaluation- using output of other employees to adjust an employees
compensation contract, relative performance evaluation e.g. better than others get compensations
But two agents may face different shocks (economic or market condition) may lead to worse results
by using relative performance evaluation
- aim to reduce chance that uncontrollable factors affect performance
- from informativeness principle, if important source of info about effort is the output of co-workers
it should be used

Within-firm performance: Problems: no job identical; - those who excel can be punished
- allocated to a weak group

Across-firm performance: - average performance of other firms reference
- Problems: lack of data, anti-trust laws (competition law -commutation between competitors may
result collusion), non-common shocks can increase risk on employees

Objective performance evaluation employee may only focus on a few one or two tasks; firms often
augment its objective explicit measures with subjective yet comprehensive measures of
performance (SPE) Subjective performance evaluation (SPE): overall prefermence
- SPE, expensive to accurately measure all things
- Multiple tasks: pay for one output, not the other bias effort towards first output
Problems with SPE: - shirking by supervisors; - influence costs (bought up supervisor);
- reneging (firm reneges on promise to reward good work)

Team output (moral hazard in team)
O
F
= 10e
1
+ 10e
2
O
F
: Output of firm= revenue
Work are individual rational, selfish worker; no risk averse workers
Profit = revenue cost (assume cost is only wages)
Profit= 10e
1
+ 10e
2
- w
1
- w
2

Firm make zero profit, revenue=wages *Rule: balance budget output = wages
10e
1
+ 10e
2
= w
1
+ w
2

Distribution rule: each worker get half of wage (wage=output)

First-best outcome Max net surplus
Surplus = revenue or output - effort cost

Derive e
1
: 10 - 2e
1
=0 e
1
=5
Derive e
2
: 10 - 2e
2
=0 e
2
=5
Either worker 1 or 2 receive full marginal benefits of effort (10), and bears full marginal cost (2e
i
)

Second-best outcome - Firm cannot observe e
i
, only can observe total output O
F

We got issue of output in teams, team problem make firm cannot get first- best outcome; Second-
best outcome is see the surplus we get when market failure / imperfection
Each worker maximises own utility!
2
, 1, 2
i i i
U w e i
2
1 2
1
10 10
F i
i
e e w

2
1
F i
i
O w

1 2
10 10
, 1, 2
2
i
e e
w i

2 2
1 2 1 2
10 10 S e e e e
Utility= Wage Effort Cost
Derive e
1
: 10/2 - 2e
1
=0 e
1
= 2.5
Derive e
2
: 10/2 - 2e
2
=0 e
2
= 2.5
Each worker receive half of marginal benefits of effort, but bears full marginal cost Externality
Worker going to put less effort since they cannot get full marginal benefits of effort.
MB,MC MC=2e
i


10 MB

5 MB (team)

2.5 5 e
General result: moral hazard in teams results in less than efficient effort level
Why? Because of Externality: worker cannot get full return of efforts.
Need to give each worker their full marginal benefit in order to get first best
Balance of budget: Total output = Total wage MB=MC

But budget constraint violated: not possible to give each worker full MB of effort and balance the
budget w
1
= O
F
& w
2
= O
F
w
1
+ w
2
= 2*O
F


Monitoring the monitor
Worker Manager Owner
Worker effort into production
Manager reports to owner on worker effort
Owner faces two problems
- need to motivate worker to work at appropriate level of effort
- provide manager with incentives to tell the truth ie be on the owners side (not the worker)
General problem: bureaucrat regulating firms, police etc

2 1 2
10 10
, 1, 2
2
i i
e e
U e i

1 2
10 10 , 1, 2
i
w e e i
5 i e
The trade-off between risk and incentives
Traditional trade-off: -cost of performance pay increasing with risk faced by risk-averse agent, as
need higher expected wage to compensate agent for facing uncertainty. More uncertainty
environment Less likely use of incentive contract
- trade-off for firms - benefit of more effort versus higher wage costs
Prediction: Risk imposed on workers is increasing in the uncertainty of the environment
Standard empirical prediction is that incentive pay is lower in more uncertain environments
But empirically, not convincing evidence showing relationship between pay for performance and
observed measures of uncertainty. Some measures suggest a positive relationship.
Another effect of uncertainty what project to do?
Result: Delegation (so agent decides what to work on) more likely when greater uncertainty about
what agent should be doing
Tradition model: uncertainty about relationship between effort and output
New alternative model: uncertainty about the project (What project should to do? Local agent
choose the project, principal provide incentives to do right things)
- when agent has discretion need output-based incentive pay to constrain their choice (i.e more
uncertainty, more use of output based incentive pay)
- in more certain environments, firms more able to assign tasks to workers and monitor inputs (i.e
less incentive pay)

Divisional performance evaluation:
Most organisation have some subunits grants some decision rights and evaluated on
performance (note organisational architecture performance evaluation and reward systems are
consistent with decision rights granted to unit manager)
Each unit can be characterised into 1 of 5 categories based on the decision rights it has been granted
and the way its performance is evaluated.

1. Cost centre: produce an output at minimum cost
- cost centres assigned decision rights to produce a stipulated level of output; in achieving this
units efficiency measured and rewarded
- granted decision rights for determining mix of inputs used to produce output
- managers evaluated on their efficiency in applying these inputs to produce output (not judged on
selling output, revenue, profit)
- output must be measurable
- because it retains the decision rights to specify the departments output or budget, central
management must possess the requisite specialised knowledge (understand budget constrain)
- quality must be monitored effectively

Various objectives are used to evaluate cost centre performance
(a) minimise cost: set q*, managers need to produce at min cost (choose efficient input mix)
(b) max output: max output for specified budget; same incentives, as need to select cost
minimising input mix to produce q*
(c) minimize average cost(ATC): (Note: min ATC not the same as maximising value (MR = MC is not
necessarily the same as ATC minimised) (MR=MC profit maximize)

In summary central managers need understanding of units cost structure, determine value-
maximising output level, monitoring quality and set up appropriate rewards; cost centre manager
needs specific knowledge of optimal input mix
Expense centre:
- activities such as personnel, accounting, patenting, public relations and R&D
- expense centre manager given fixed budget and asked to max output
- difference with cost centre is expense centre is output in expense centre measure more
subjectively - ie cost centre with output not easily measured

Implication users not charged directly, hence personal expense center my over-demand
- have a tendency to increase in size (centre grows faster than whole organisation)
- could use benchmarking against other firms
- reorganise under control of largest user

Revenue centres: maximize the revenue; can choose not only input mix but also output
- marketing activities of selling, distribution, servicing finished product
- regional sales manager given budget for expensies etc and has decision rights over budget to max
revenue
- consistent, if prices-budget set combination correct with value maximisation (senior manager set
the price the revenues centre maximize revenue by choose quantity)
- cannot give decision rights over both price and quantity, as set level to where MR = 0
Profit centres: max profit, more decision right
- comprised of several cost and possibly expense and revenue centres
- given a fixed capital budget and allocated decision rights for input mix, product mix and setting
prices (or output qs)
- knowledge required to make product mix, quality, price and quantity decisions specific to the
division and this info is costly to transfer
- managers rely on internal accounting systems(transfer price)to provide performance evaluation
- evaluated on difference between actual and budgeted accounting profits for their division
Investment centre
- similar to profit centres, additional decision rights for capital expenditure and are evaluated on
measures such as return on investment
- manager of unit has specific knowledge about investment opportunities as well as information
relevant for making units operating decisions
- often comprised of several profit centres
- all the decision rights of a profit centres + decision rights overamount of capital to be invested.
Two measures of performance of investment centres:
(a) return on investment % ROA opportunity cost
(b) residual income( absolute income generated)

Transfer pricing: tax saving - sell products or services between units within a firm
Transfer price price of product traded within firm (between divisions)
The choice of transfer-pricing method reallocates total company profit within business units; it also
affects total firm profits reason: - managers make decisions based on transfer price
(affect reward in 2 divisions result incentive to make real decisionaffect total profit)
- transfer price do not reflect resource values effectively, managers will make inappropriate
decisions
Set transfer price at opportunity cost of that input, marginal cost

Double marginalisation problem- In final
With costless information: - MC of producing in unit A is $3 - unit B can sell product for $5
Alternatively A could sell product in market for $6
With asymmetric information: - division manager only party who knows MC
- Output demand P = 110 5q, MC = 10
- 2 units manufacturing (MC = 10 per unit) and distribution (MC = 0)
Profit max:
Profit= (equilibrium price marginal cost) * quantity = (110 5q 10) * q
Derive q: 100 10q=0 q*=10 P*= 110 5(10) = 60
Max Profit = (60-10)*10 = 500
Now assume manufacturer sets transfer price and sells input to distribution unit for Pt, then
distribution unit sets final output price Pd (solve this problem backward)
profit A + profit B two division get reward based on maximizing their own profit
Profit for distribution = (110 5q pt: constant marginal cost for distributor)*qd
Derive qd= 110 10qd pt = 0 qd= (110 pt) / 10
Solve backward substitute qd into manufacture profit maximizing
Profit from manufactory = (transfer price marginal cost) *qd = (pt 10)* [(110 pt) / 10]
=(pt 10)*[11 (pt/10)] = 11pt (pt*pt) /10 110 + pt
Derive pt: 11 pt/5+ 1 =0 pt = 60
qd= (110 60)/ 10 = 5 pd = 110 10*5 = 85
profit for manufactory= (60 10) * 5= 250 profit for distribution= (85 60)*5= 125
Total profit for transfer price= 250+125=375 Maximum profit=500
Double mark-up problem: transfer price is too high, transfer price is the marginal cost for distributor,
and the distributor will put some margin on the transfer price (pt 60), this lead to decrease in final
quantity sold. Due to each division wants to have their margin to maximize profit. However the true
marginal cost (true opportunity cost) for the firm is 10 (not pt 60), the overall price too high lead to
hurt the total profit for the firm.


Common transfer price methods
Market based transfer prices: - measure costs and benefits or resources
Problems: typically use internal market when internal sourcing is more efficient
- measures from market not accurately reflect opportunity cost of internal production
MC transfer prices
- difficult to measure; - fixed cost recovery; - revelation of info; - non-constant MC;
- capacity? : Quality

Negotiated prices: - share spoils
Time consuming: - negotiated over P but not Q at the same time, no guarantee arrive at the Pt
(transfer price) that maximises firm value.
Transfer is marginal cost profit maximizing; - Can use a fixed fee to transfer profit.

Trade-offs in performance evaluation and accounting systems: transfer price rely on information
about cost. Although helpful for decision management, accounting systems more useful for decision
control - historical data (stop fraud theft )
Trade-off:
(1) accounting mergers not under control of those being monitored
(2) DM managers use other non-financial data, non-financial more timely and less aggressively
Must choose tradeoffs between DM and DC when setting up allowing system - ie transfer pricing
- method that most accurately reflects opportunity costs to firm might not be method that gives
internal managers the most effective incentives to max firm value
- set prices at opp cost, managers incentive to inflate prices and affect their performance evaluation
Decision management (DM) has different requirements than decision control (DC)
For example, given the reward system, transfer-pricing method that is less subject to managerial
discretion might be a more accurate method of determining opportunity costs than one
that requires managers to disclose private (non-verifiable) information

Costs and benefits of choosing between alternative firm sizes
Make or buy decision: What should a firm make and what should a firm buy? -Boundaries of firm
- Integrate backwards or upstream: a firm that begins to make its own inputs
- Forwards or downstream integration: additional finishing or marketing etc
In reality, there can be a continuum of options between:
- spot markets - long-term contracts - vertical integration
Vertical and Horizontal integration: industrial organisation reason really about market power
Vertical integration: production process or chian of input
Horizontal integration: two firm selling the same product
Strategic reasons: eliminate double mark-up problem and reduce DWL, more efficient, consumer
also better off
- Chicago School mergers efficient -Reason: vertically integration to avoid double mark-up
Manufactory (A) Retail(B) Customer
Demand curve: P = 55000-100q Marginal cost: MC= $ 5000 for A, B has no cost
A and B act as one profit maximizing firm:
Profit for joint= (55000 100q 5000)*q =(50000 100q) q =50000q 100q^2
Derive q: 50000 200q= 0 q = 250 p* = 30000
Max Profit = (30000 5000)* 250 = 6250000
Solve backward because A is forward thinking and rational, will think about B reaction
Profit for B = (55000 100q w: wholesale price)*q
Drive q: 55000 100q w = 0 qb= (55000 w)/200 Best response/reaction function for B
Back to A: profit for A = (w - 5000)*qb = (w - 5000)* (55000 w)/200
=275w (w^2)/200 + 13750000 + 25w
Derive w: =275 w/100 + 25 = 0
W = 30000
qb=(55000 30000)/ 200 = 125 units
pb= 55000 100*25 = 42500
profit for A = (30000 5000)*125 = 3125000
profit for B = (42500 30000)*125 = 1562500
profit for A + profit for B = 3125000 + 1562500 = 4688000 < profit maximizing: 6250000
A set wholesales price above the true marginal cost, B face to high cost, customer face to high price

Merger a way to overcome problem (although care needed setting transfer price)
But problem here is that we have restricted type of contract two firms can write with one another
Two-part tariff : A sells input to B at MC (of $5000) and charges a fixed fee (of $6.25m)
- vertical integration not needed to overcome double-marginalisation problem

Why does double mar-up disappear after merger?
Assume incentive problem will disappear after merger, but it is not true. Even this firm under a
common ownership, manager still needs manage sale department and manufactory section, and
manager still needs to motivate them. This may leads to two profit centres in the joint venture. If the
joint venture has two profit centres will generate problems like transfer pricing issue, which will
result the exactly double mark-up problem. Ignore incentive problem after merger.

Market power - vertical integration used to extend/maintain market power
Example: selling to two markets pain relief and cancer drug
- DryCo has input required for both drugs
- pain reliever market competitive - no close substitute for cancer drug
- MC = $10 for input
- drug company can turn 1 gram of input into either pain reliever orcancer drug
Demand: Pain relief: P = 100 5Q Cancer: P = 200 10Q
DryCo sets MR = MC
Pain relief market: MR = MC MR = 100 10Q = MC=10 Qpr=9 Ppr = 100 5*9 =55
Cancer drug market: MR=MC MR = 200-20Q = MC=10 Qc=9.5 Pc= 200 10*9.5=105
However, manufacturers will engage in arbitrage: buy at $55 and resell to those making cancer drug
for < $105
- to avoid this, DryCo can integrate forward and manufacture pain reliever
- price pain reliever at $55 in retail market and sell input at $105 in wholesale market
- arbitrage no longer possible
Note: integration forward into the cancer market does not work: must integrate lower-prices (more
elastic) market pain-reliever
Third degree price discrimination, charge one price for pain relief and other price for cancer drug, 2
downstream markets, charge higher price in relative inelastic market, lower price in relative elastic
market
Third degree price discrimination problem: arbitrage between markets, vertical integration can
overcome this problem, vertical integration forward into relative elastic market (cheaper market),
start to make the final product and sell it eliminate arbitrage.

Why do firms exist? - make or buy decision
Coase (1937): use firms for transaction when less costly than using the market
- trade-off between costs within firm with costs of market
Transaction costs in writing a contract
- world is unpredictable; - difficult to write specifics in a contract; - negotiation difficult
- therefore contracts are incomplete - if contracts are incomplete renegotiation will occur that will
involve redistribution of surplus of trade;
Specific relationship (investment are specific)
If assets are firm specific, renegotiation not likely to get a return on these assets (holdup)
- reducing externalities - coordination through the market - quality of input
Bring activity into firm to avoid costs of transaction in the market
- but why do these costs change inside the firm? Problematic transaction cost
Property-right approach: cost and benefit of asset ownership affect make or buy decision
Formally review holdup: invest renegotiation (expropriation)
The hold-up problem anticipating expropriation after investment has been sunk, will
underinvest (think back some surplus will loss after renegotiation )

More generally - firm invests, other firm/union extracts rents
Firm reduces/stops investing because of holdup as doesnt receive the full marginal benefit of
investment
- surplus generated R(i), where R > 0 and R < 0 R is function of i and also a concave function,
more investmentbigger R, diminishing marginal benefit and diminishing
- net return is R(i) i
First-best i R(i)=1 Max i: (R(i) i) R(i) 1=0 R(i)=1 solution i*

Ex ante ex post R(i) realised

Holdup - other party gets (1 ) of return (surplus), where 0 < < 1 negotiate just R revenue
- renegotiation occurs after i has been sunk, do not think sunk cost, so it is not part of the surplus
negotiated over
- 2nd party gets (1 )R(i) - 1st party gets R(i)
Ex ante return to investing party is (need to consider all costs/benefits) R(i) i
1st party (investing party) maximises return by solve backward
With holdup, profit for firm A= R(i) i
Differentiate i R(i) 1=0 R(i)=1 R(i)=1/ solution i^
First-best i: solution i* Holdup problem: R(i)=1/ solution i^
i^ < i* inefficient investment(underinvestment) because investor cannot get full marginal benefit
but bears dull marginal cost (externality)


Holdup can occur when contracts are incomplete (renegotiation) will occur and investment is
specific to another party
- location - GM-Fisher Body - Firm specific training
Hold-up : hold-
up

Boundaries of the firm - what does ownership involve?
- right to do as wish with asset when a contract does not specify what should be done
- residual right
- these rights are important when contracts are incomplete
For example, something new happens not specified in the contract that requires firm to renegotiate
- in this case the owner of the asset can say what gets done with it: this translates into more
bargaining power(bargaining power means get more surplus during renegotiation)
- more bargaining power may allow an individual to get more surplus from renegotiation
- ownership encourages investment ex ante: increase return increase incentive to invest
Costs other party does not get as much ex post surplus, so they will reduce
their investment ex ante
Property-rights model:
1 Two parties essential for trade A upstream makes input y for B downstream
2. Outside option for both parties 0 (trade efficient)
3. Only one asset (x) needed for trade to be completed.
4. A can make investment e and B can make investment i to increase value of trade (reduce the cost
of final input y)
5. Contracts incomplete; renegotiation will occur after investments have been sunk

Ex ante Ex post (contracts can be written)
Cost: e for A, i for B; sunk investment spilt surplus between parties after i and e sunk
Ex post returns (benefit and cost):
For B: benefit = R(i) + R where R(i) > 0 and R(i) < 0 greater ex ante invest, greater return
For A: cost= C C(e) where C(e) > 0 and C(e) < 0
B invests i at cost at i, A invests e at cost at e
Ex ante surplus
A: C C(e) + e B: R(i) + R i A and B: concave curve- surplus increase at a decreasing
rate e, i : sunk cost
Surplus-ea = R(i) + R i [C C(e) + e]
Ex post surplus (after i and e sunk cannot change sunk investment)
Surplus-ep = R(i) + R [C C(e)]
First-best ex ante investment (benchmark: maximum surplus)
Differentiate i R(i) 1 =0 MB =MC R(i) = 1 i*
Differentiate e *C(e) + 1+=0 MC = MB C(e) = 1 e*
Real trade-off: the asset owner have more bargaining power and willing to invest more, but the
other party does not own asset and will invest less or invest zero
Ownership important more bargaining power Assume owner of asset has all of bargaining
power and get all of ex post surplus set price P (take it or leave it offer)
A has ownership, ex post: A set price as much as buyer B willing to pay p = R(i) + R
A sets e to maximise: { price cost = R(i) + R [C C(e) + e]}
choose e to maximise {price cost} Differentiate e *C(e) + 1+=0 C(e) = 1
A will invest e*, because A bears full marginal cost of investment and also get full marginal benefit of
return, no externality, so A will put effort same as first best of ex ante investment
With A ownership, A invest e*, however, B invest ex ante, B sets i so as to maximise (benefit price)
Max : R(i) + R i [R(i) + R] Max: ( i) set i^= 0 B have no incentive to invest
Result: under A ownership B invests nothing i = 0 and A invests e*
If B has ownership, during renegotiation (ex post) B has all the bargaining power, so will set price p
at lowest level (minimum price level = marginal cost) that A is willing to still supply the good at:
p = C C(e)
Backward solve problem
Ex ante investment given the price
B max i : R(i) + R i [C C(e)] first order condition: R(i) = 1 if B own asset, B will invest i*,
because B bears full marginal cost of investment and also get full marginal benefit of return, no
externality, so B will put effort same as first best of ex ante investment.
With B ownership, B invest i*, however,
As ex ante maximisation problem: maximise price costs, or max C C(e) *C C(e)+ e
A choose e max ( e ), set e^ = 0 A has no incentive to invest
Bs maximisation problem ex ante: max R + R(i) i C C(e)
Result: A invests e = 0; B invests i*
Advantage: asset ownership gives a strong incentive to invest
Disadvantage: Real trade-off problem, other party invest zero, not max surplus, not at most
efficient level
So who should own the asset?
With A ownership Surplus for A ex ante: Sea = R i [C C(e*) + e*]
With B ownership surplus for B ex ante: Sea = R +R(i*) i* C
A ownership is better if: Surplus for A ex ante > surplus for B ex ante
R C + C(e*) e* > R + R(i*) i* - C or if C(e*) e* > R(i*) i*
This is way to increase value of trade; A should own asset when A investment is more important and
/ or A contribution is larger
B ownership better if: Surplus for A ex ante < surplus for B ex ante
R(i*) i* > C(e*) e*
This is way to increase value of trade, B should own asset when B investment is more important and
/ or B contribution is larger
Proposition: A owning the asset is (second-best) surplus maximising when As investment is
relatively more important than Bs investment (C(e*) e* > R(i*) i*)
B owning the asset is (second-best) surplus maximising when Bs investment is relatively more
important than As investment ( R(i*) i*) > C(e*) e* )
What about?
(1) Bargaining power: - provided asset ownership gives the party greater surplus, similar result holds
(2) More assets: - take 2 assets: can have separation, A owning both assets, or B owning both assets
General principles:
(a) Agent with important investment should own asset
(b) Agent who is (relatively) more responsive to asset ownership should own asset
(c) With more than one asset, complementary assets should be owned together
Summary: Asset ownership provides residual control, which in turn provides bargaining power
during renegotiation. This additional bargaining power provides an incentive to invest
- asset ownership encourages investment; - not owning an asset discourages investment
Limitation: (1) model of owner- operated firm, small firms not big corporation
(2) In reality have bargaining solutions e.g. constant return for other party
Uncertainty likely to motivate ownership of specific asset
- increases the likelihood of renegotiation
- on the other hand, in certain environments a contract can cover most contingencies, lessening the
chance of holdup
Activity frequently outsourced (long-term contract): -catering , trucking, computing services
Spot market is not appropriate, but assets are not firm specific
- Low potential for holdup - easy to write a complete contract
Specific assets
- likelihood of vertical integration increases with specificity of asset
- less specific asset, more likely market transaction or
long-term contract produce efficient investment incentives

Corporate governance
Publicly traded corporations
Corporation have the legal standing of an individual (distinct from its shareholders)
It can enter into contracts and participate in law suits
Corporations have rights to issue stock
Laws require board of directors primary decision control rights for the firm
Shareholders have limited liability (only their initial capital contribution subject to risk; they are not
legally responsible for the debts of the company)
Some corporations held closely; others publicly traded
Three types of shareholders: Small; institutional e.g. super fund ; block holders (family
hold firm share)
Stock ownership patterns
Institutional stock ownership increased
Widely held (no one owner controls more than 10 per cent of the shares), in 1995 in the US
80 per cent of the largest firms and 50 per cent of medium-sized firms were widely held
Governance objectives
Corporate governance the organisational architecture at the top of a corporation.
Focuses on the allocation of decision rights among shareholders, board of directors, top managers
and external monitors (independent auditors, regulators, stock exchanges)
Corporate governance
Governance systems evaluated to:
The motivation of value-maximising decisions
The protection of assets from unauthorised acquisition, use or disposition
The production of proper financial statements that meed the legal requirements
Separation of ownership and control
With separation of ownership and control, corporate decision makers will have weaker incentives
to use assets productively (than owner/managers)
Why use a publicly traded company then?
Top-level architecture
Organisational architecture of typical corporation does not give absolute authority to professional
managers
Decision rights divided among shareholders, the board of directors, top management, and external
monitors
Similar principle as separating decision management and decision control
Three types of shareholders: small, institutional; blockholders All have differing incentives
Board of directors
Board of directors primary function is top-level decision control (ratification, monitoring)
to provide general oversight of the corporation and to ratify important decisions
Delegates most day-to-day decisions to professional managers
Duty to shareholders
One of main tasks to monitor, compensate and, if required, replace the CEO
Board of directors
Structure of board differs depending on the legal requirements and the practical needs of a
particular firm
Some critics question the independence of boards, especially when they have limited outside
members
Top management authority and incentives
The CEOs decision authority flows from the board of directors
Most decisions are delegated further; focus of CEO more of broader corporate-level questions?
Often use a team of executives; CEO concentrates on external activities while the COO
concentrated on managing internal operations
Incentives at the top
Bebchuk and Fried (revisited)
1. Typical corporate board captured by management; 2. Better governance reduces capture; 3.
Managers want high rents (not performance-based pay); 4. Public outrage places a constraint on
excessive pay; and 5. Competition in product, labour and takeover markets limit executive pay, but
not perfectly
Empirical predictions:
Level of CEO compensation is expected to be lower in firms with better governance
Top managers expected to receive more incentive-based compensation in firms with better
governance
Firms camouflagecompensation to avoid stark disclosure (ie retirement
compensation schemes)
External monitors
External parties monitor corporate decisions
public accounting firms, stock market analysts, commercial banks, credit-ratings agencies and
regulatory authorities
For example, independent auditors bonding mechanism
But how independent are these auditors?
Similarly, stock market analysts provide information to potential investors
Ratings agencies (S&P, Moody and Fitch) rate corporate debt of large companies for default risk.
But companies pay the rating agencies to rate their debt issue. Conflict of interest?
External monitors - regulators
What is the rationale for regulation and requirements of disclosure/reporting?
What market failure are regulations correcting?
Is it possible private institutions could generate similar institutions? How to collect enough
information?
External monitors - regulators
Costs of complying with regulations significant
Benefits possible come from fostering investor confidence in system, increasing aggregate
investment (as well as investment in specific projects)
Disclosure of information could assist the market forces, particularly in the managerial and
corporate control markets

Motivating change
Leadership is more than developing a vision for an organisation
- need to motivate others to implement that vision
- firms organisational architecture can play a pivotal role
- marketing concept also important
Leaders- leading others along a way, guiding
Two characteristics of leadership: - vision or plan; - motivate people to follow that vision
Developing the vision
- organisational architecture should be designed such that it motivates employees with specific
relevant specific knowledge to initiate value-enhancing proposals
- empower employees
Motivating
- charisma , important, but employees influenced by economic incentives provided
by architecture
- implementing a new decision is often subject to self-interest within a group setting
Attitudes towards change gaining support for change

status quo on IC curve is zero
Proposal design
Maintaining flexibility:
- people more likely to suppose a new proposal if it entail lower risk
- could start with a limited pilot program (small scale)
Commitment: - strategic value of making a commitment to change
Distributional consequences: - some employees will gain, others will lose from the change
Marketing a proposal
Careful analysis and groundwork: reduce uncertainty
- risk averse individual more likely to favour status quo - communicate with employees
Relying on reputation - a leader with a good reputation is more likely to be listened
Emphasizing a crisis - argue that current situation is worse than thought, and will only get worse
Organisational (power from knowledge)
An employees attitude towards change depends on the power of the person
- to be effective it is important for managers to understand the sources of this power and how to
acquire it
Sources of power:
- formal authority; - control of budgets and resources; - control of information; - friends and allies
Power- Tying the proposal to another initiative
- claim project is integral part of project that is already approved
Coalitions and logrolling ;
- coalition of parties with differing interests that band together to support each others projects
- credibility that will support others projects in the future;
- identify potential logrollers?
- how specific should you make the proposal?
The use of symbols : - use informal methods and messages to complement formal architecture
Formal corporate plan: communicating to employees objective of organization
Opposing change
There are many examples of a union opposing a surplus-enhancing innovation or change
- print unions opposed new computer technology (UK)
- automotive union opposed new work practices & technology (USA)
- shearing unions opposed wide combs (Australia)
Reason oppose a surplus-enhancing change:
Consider a union and a firm
- the firm wants to implement a new change that will increase total surplus (a new work practice)
- there are two periods
- if the change is implemented generates v1 surplus in period 1 and v2 in period 2
- union has bargaining power, so it can effective oppose change and it can capture (at least) of the
surplus in that period, but 0 thereafter
- contracts incomplete, so it is not possible to make commitments about future periods
Second period
-If innovation has not occurred already, it will
- surplus split v2 for union; (1 )v2 for the firm is the measure of the bargaining power
If innovation had occurred in period 1, the innovation will remain, and the union will have lost all of
its bargaining power: - surplus split 0 for the union; v2 for the firm
First-period innovation
Focus on unions decision (as the firm always wishes to innovate because if firm does not innovate,
firm will gets 0)
If there is change in the first period the union gets at least: (v1 + 0)
Union know they can get v1 in period 1, but get 0 in period 2, and some compensation for loss in
period 2. (v1 + 0 + c)
Firm can use the current surplus to compensate, the maximum compensation c firm can pay is the
maximium amount of surplus: c = (1 )v1
This comes from v1 from bargaining power, and firm is willing to pay (1 )v1 as an extra
inducement to change
Outcome is union gets: v1 + 0 (this is the maximum payoff union can get)
Alternative, union did not agree in first period, union gets 0 in first period and v2 in second period
If there is no change in the first period, the payoff to the union is: (0 + v2)
Union will oppose innovation when: v1 + 0 < 0 + v2 or when > v1 /v2
No asymmetric information; No uncertainty, no risk averse; instead hold up
A union opposes change when
- there is a long-term relationship (many periods)
- innovation today affects bargaining power in the future
- future losses cannot be adequately compensated for today
- it is not possible to make promises about the future
Overcome opposition by addressing these concerns