Summary
Samenvatting Organizational Economics
- Course
- Institution
Summary for the course Organizational Economics (2013/2014). Also includes lecture slides text
[Show more]
1 review
By: dennysellis • 6 year ago
Seller
Follow
xMarliah
Reviews received
Content preview
Organizational EconomicsLecture Week 1.
Organizations are:
i. “...systems of coordinated action among individuals and groups whose preferences,
information, interests, or knowledge differ (March and Simon, 1993)”;
ii. Organizations are a means of achieving the benefits of collective action in situations
where the price system fails (Arrow, 1974, p. 33).
Examples of organizations: firms, but also governments, schools, churches, political parties,
etc. All of them share the common characteristics of the need for collective action and the
allocation of resources through non-market methods (Arrow, 1974, 26). Organizations
allocate capital, employ people, and interact with other organizations.
The Fundamental Welfare Theorem (FWT) and the Coase Theorem make explicit the
circumstances under which markets do function well and hence also when you would expect
other organizational structures. However, the fundamental welfare theorem (FWT) and the
Coase theorem require a number of strong assumptions.
The causes for failure of the market system are: incomplete information, asymmetric
information, market power, limited cognition and externalities. Many things can go wrong in
markets and justify other forms of organizing transactions.
The Fundamental Welfare Theorem (FWT)
Organization of transaction via the market has advantages if:
- Each firm maximizes its own profits, knowing the prices and its own production technology;
- Each consumer maximizes utility, knowing the prices and his or her own preferences;
- Income and prices are such that demand equals supply for every good and service.
Then the resulting allocation of goods and services is Pareto efficient.
The main prediction of FWT is that the market system (price mechanism) resolves
coordination and motivation problems perfectly, under certain circumstances. Furthermore,
prices serve to inform the parties about what they should do in order to take good decisions in
the neo-classical model. The Welfare theorem specifies assumptions such that coordination
and motivation problems are solved. Some assumptions are: no market power, many
consumers and producers, complete rationality, no externalities / public goods.
The Coase Theorem extends the domain of the FWT to a small number of agents and
externalities. It states that if:
1. Property rights are assigned and enforced;
2. Bargaining is efficient, and;
3. Preferences do not display income effects;
Then (i) every allocation of property rights will result in a Pareto-efficient allocation of
resources, and (ii) this resource allocation is independent of the assignment of property rights.
N.B. De stelling van Coase, of het Coase-theorema, stelt dat particuliere economische
deelnemers het probleem van externe effecten onderling kunnen oplossen. Hoe de verdeling
van de rechten ook is, de partijen kunnen altijd een overeenkomst bereiken waarbij het
resultaat voor iedereen beter is.
Markets achieve the best allocation of resources according to the fundamental welfare
theorem (FWT) and the Coase theorem. Either result though requires a number of strong
assumptions. The fundamental welfare theorem and the Coase theorem make explicit the
circumstances under which markets do function well and hence also when you would expect
other organizational structures.
, Coordination and motivation limit the
degree of specialization. The main task of
economic organizations is to coordinate
transactions and to motivate people →
information plays an important role. Firms
are a good alternative to markets
(competition) to achieve coordination and
motivation.
Contracts
Contracts are used as a device to solve coordination and motivation problems. Types of the
contracting approach to organizations:
- A firm consists of various parties with different interests;
- A firm as a nexus (network) of bilateral contracts between stakeholders;
- A firm as one party to each of the many contracts that make up the firm (firm as focal point
for a set of contracts).
Hendrikse: A contract is a document that specifies the rights and obligations of the players.
Milgrom and Roberts (1992): A contract is economic jargon for agreements that modify
behaviour in ways that are mutually beneficial. These agreements may encompass sorts of
actions, payments, rules/procedures and behaviour.
The term contract does not necessarily refer to the legal status: they can be implicit. An
important feature is that contracts help align incentives, i.e. facilitate cooperation, and thereby
(intend to) improve efficiency.
• Complete contingent contract: fully contingent (conditional) on every relevant
characteristic of every possible situation (‘state of the world’). Parties thus foresee all
relevant contingencies and can describe them in a verifiable way. They agree upon an
efficient course of action for every possible contingency. “The complete contingent
contract specifies all parties’ obligations in all future states of the world” (Hart, 1995,
p. 22). Parties abide to the terms of the contract; i.e. they have no incentive to
renegotiate or to unilaterally breach the contract.
• Complete contract: When some relevant information is not publicly available, parties
cannot contract upon an efficient course of action for every relevant contingency (state
of the world). But they do so whenever possible. “A complete contract specifies all
parties’ obligations in all future states of the world, to the fullest extent possible”
(Hart, 1995). There will never be a need/incentive for the parties to revise or
renegotiate the contract as the future unfolds (for, if so, this change can be anticipated
and built into the initial contract) → no "gaps" in the contract. Parties cannot do better
given the incentive/information constraints they face (incentive efficiency).
• Incomplete contract:
There is unfortunately no clear definition of "incomplete
contracting" in the literature (Tirole, 1999, p. 743). “Incomplete contracts do not
specify all parties’ obligations in
all future states of the world to the
fullest extent possible.” There are
"gaps" in the contract; not all
relevant aspects of exchange are
covered, so there is room for
"improvement".
,Economic Organizations and Efficiency.
Organizations are evaluated on the basis of how well they satisfy the wants and needs of
people (represented by their utility functions) → organizations are evaluated on the basis of
their efficiency. Efficiency is the best choice for all parties involved (highest total joint
surplus) and is determined by using the value maximization principle. For efficiency to hold,
it doesn’t matter who has the decision rights. (!) Efficiency & the decision made are different
things.
Value Maximization Principle: an allocation among a group of people whose preferences
display no wealth effects is efficient only if it maximizes the total value (total surplus) of the
affected parties. Applying the Value Maximization Principle: the issue of division of
value/welfare is separable from the issue of how value is created.
The Principal-agent model has three ingredients:
1. Surplus available: Opportunities for value generating exchange;
2. Conflict of interests: Preferences are not perfectly aligned;
3. Asymmetric information: Agent has more information than principal.
Asymmetric information excludes (meaningful) complete contingent contracts. Therefore,
coordination and motivation (incentive) problems become an issue. These problems are
typically analysed within the principal-agent paradigm.
Types of asymmetric information are:
! Hidden action: agent has private information on what he/she does, i.e. the decisions
he/she takes within the contractual relationship (possibly moral hazard behaviour by
the agent);
! Hidden characteristics: agent has private information on who he/she is, i.e. what
his/her characteristics are (possibly adverse selection behaviour by the agent).
The sequence of decisions in the principal-agent model:
1. The principal designs the contract (menu of contracts);
2. The agent chooses whether to accept the contract (and which one);
3. The agent takes decisions within the contractual relationship (execute task, e.g.
effort/investment).
Performance measurement systems are required to
increase company value by giving incentives to
managers and employees. Motivating them to work
hard on the right things and selecting the right people
with ability is important. There are huge problems
attached to designing good performance measures and
to communicating them. Theory can be used to solve
some of the issues. (Figure: the higher the motivation,
the higher the performance. ‘Extrinsic’ indicates that employees are motivated when there are
monetary payoffs (paying employees for output makes them motivated). ‘Intrinsic’ means the
employees are motivated (derive utility) from just doing a task.
!! Principal-Agent model: see slides !!
, Lecture 2.
Principal Agent Model: Basic Agency Theory
Simplicity is assumed: one employer (principal) and one employee
(agent). The principal is too busy and hires the agent without the
opportunity for perfect monitoring. One way to motivate the agent is
incentive contracting. The basic PA model of incentive contracts is
very restrictive and simple. Will become richer and thereby more
realistic I essential building block.
Employer offers reward for output (somehow measured). Assume
that output can be measured y = fa + ε where a
is employee effort and ε is a noise term.
Risk aversion: Prefer a certain amount I over an
uncertain amount Y, where E(Y)=I
Certain Equivalent: Certain income that is
equivalent, from decision maker’s point of view,
to a given random (uncertain) income.
Suppose that an individual’s utility is given by
𝑈 𝑌 = 𝑌. What is the Certain Equivalent of a
lottery that yields 0 with probability of 50% and 100
with a probability of 50%?
! !
" 𝑈 𝐶𝐸 = ! ×𝑈 0 + ! ×𝑈(100) gives CE=25 or
! !
(𝐶𝐸) = ! × 0 + ! 100 → 𝐶𝐸 = 25
So the individual is indifferent when CE=25
Risk premium (RP) = difference between E(Y) and CE.
- Concave curve = risk aversion;
- Convex curve = risk-loving;
- Linear curve = risk-neutral.
If CE=30, in this case, then it means you are less risk-
averse and RP=50-30=20.
Risk lovers have negative RP’s, because they are willing to pay to take some risk.
An incentive compensation based on the measured performance imposes a risk on the agent
- Incentive pay: w(y) = s +by
- Output measured by y=fa+ε, ε is noise term that cannot be controlled by the agent.
Recall assumption: Agent is risk-averse. A risk-averse agent dislikes risk and wants to be
compensated for additional risk. Note that variable compensation based on effort (i.e. a) (if
observed) imposes no risk on the agent. Also a fixed income imposes no risk on the agent.
r = Coefficient of absolute risk aversion.
If r = 0: risk neutral, r > 0: risk averse, r < 0: risk lover Know
by
! !
Risk premium: ! ∙ 𝑟 ∙ 𝑉𝑎𝑟(𝑦) Certain equivalent of y equals: 𝐸 𝑦 − ! ∙ 𝑟 ∙ 𝑉𝑎𝑟(𝑌) heart!
Principal Agent Model:
1. The principal designs the contract
2. The agent chooses whether to accept the contract or not
3. The agent takes decision within the contractual relationship; i.e. decides how much effort to
exert.
,- Output (Production Function): y = fa + ε
- Wage scheme: w(y)=s+by
- Profits: y – w(y)
! !
- Employee’s certain equivalent: 𝐸 𝑤(𝑦) − 𝐶 𝑎 − ! ∙ 𝑟 ∙ 𝑉𝑎𝑟 𝑤 𝑦 , 𝑤ℎ𝑒𝑟𝑒 𝐶 𝑎 = ! 𝑎!
Employee’s outside option V ; Employer’s outside option 0; Employer’s CE= y – wage
The way to find the optimal wage scheme (use backward induction):
# Step 1 (Incentive Compatibility Constraint): Determine how the employee behaves
under different wage schemes, taking as given that he is willing to participate:
!
→ Employee’s certain equivalent wealth: 𝐸 𝑤 𝑌 − 𝐶 𝑎 − ! ∙ 𝑟 ∙ 𝑉𝑎𝑟 𝑤 𝑌
→ 𝐸𝑤 𝑦 = 𝑠 + 𝑏𝑓𝑎 given E(ε)=0 and y =fa + ε
→ 𝑉𝑎𝑟 𝑤 𝑦 = 𝑉𝑎𝑟 𝑠 + 𝑏𝑦
→ 𝑉𝑎𝑟 𝑏𝑦 = 𝑏 ! 𝑉𝑎𝑟 𝑦 = 𝑏 ! 𝑉𝑎𝑟 𝜀 = 𝑏 ! 𝜎 ! given 𝑉𝑎𝑟 𝜀 = 𝜎 !
!
Hence, employee’s certain equivalent = 𝑠 + 𝑏 ∙ 𝑓𝑎 − 𝐶 𝑎 − ! ∙ 𝑟𝑏 ! 𝜎 !
Agent chooses a such that his CE value is maximized: take first derivative to a.
𝐼𝐶𝐶: 𝐶 ! 𝑎 = 𝑏𝑓
!
In this model 𝐶 𝑎 = 𝑎! , hence ICC: 𝒂∗ = 𝒃𝒇
!
# Step 2 (Participation Constraint): Derive the level of fixed compensation necessary to
attract the employee for all wage schemes:
! !
Employee’s utility if working for this firm: 𝑠 + 𝑏 ∙ 𝑓𝑎 − ! 𝑎! − ! ∙ 𝑟𝑏 ! 𝜎 ! . We know from step
! !
1 that a*=bf. So, employee’s utility if working for this firm: 𝑠 + ! (𝑏𝑓)! − ! ∙ 𝑟𝑏 ! 𝜎 ! .
Employer must choose s and b such that employee is willing to work for the firm (PC), so
1 1
𝑃𝐶: 𝑠 + (𝑏𝑓)! − ∙ 𝑟𝑏 ! 𝜎 ! ≥ 𝑉
2 2
s and b will be set such that the employee is just indifferent. This gives:
1 1
𝑠 = 𝑉 − 𝑏𝑓 ! + ∙ 𝑟𝑏 ! 𝜎 !
2 2
So, fixed compensation s increases with outside option V and with the level of risk aversion.
# Step 3 (Profit-Maximizing wage Scheme):
Employer chooses s and b as to maximize profits. Employer’s profits: 𝐸(𝑦 − 𝑤 𝑦 )
𝐸 𝑦 = 𝑓 ∙ 𝑎 and 𝐸𝑤 𝑦 = 𝑠 + 𝑏 ∙ 𝑓 ∙ 𝑎, given 𝐸 𝜀 = 0
From step 1 (ICC): 𝒂∗ = 𝒃𝒇
! !
From step 2 (PC): 𝑠 = 𝑉 − ! 𝑏𝑓 ! + ! ∙ 𝑟𝑏 ! 𝜎 !
! !
Substituting and rewriting gives employer’s profit: 𝑏𝑓 ! − 𝑉 − ! 𝑏𝑓 ! − ! ∙ 𝑟𝑏 ! 𝜎 !
Employer chooses b as to maximize profits, so takes the first order condition to b:
𝑓!
𝑓 ! − 𝑏𝑓 ! − 𝑟𝑏𝜎 ! = 0 → 𝑏 ∗ = !
𝑓 + 𝑟𝜎 !
Optimal b does not depend on V and decreases with level of risk aversion.
The Incentive-Intensity Principle.
!!(!)
In Hendrikse, the profit maximizing b equals: 𝑏 ∗ = !!!!! !"(!)
The optimal incentive intensity depends on four factors: (1) Incremental profits created by
additional effort: f’(a) (2) The precision of the performance measure: Var (ε) = σ2. (3) The
agent’s risk aversion: r (4) The agent’s responsiveness to incentives: ∂a/∂b = 1/C”(a).
, Participation Constraint: The principal must choose s and b such that the agent is willing to
work for the firm. Agent’s Certain Equivalent ≥ Outside Option.
Difficulties of Incentive Systems.
• Damaging intrinsic motivation. Intrinsic motivation means that an activity has a
motivation of its own, independent of any reward.
Providing a monetary reward for
this activity may result in a reduction of the overall motivation. Monetary reward
"crowds-out" intrinsic motivation. Some studies show that monetary incentives are not
always better (“pay enough or don’t pay at all), because excessive rewards can
sometimes result in a decline in performance;
• Multi-task agents;
• No availability of good performance measure. When good objective performance
measures do not exist, wages might also depend on subjective performance measure.
• Wages might depend on subjective performance measures
Strong assumption in basic agency theory: y can be measured. In the classical model, y
reflects everything the principal cares about (except for wage costs). Hence, y is the agent’s
total contribution to firm value. In many settings it is very difficult to measure y. Alternative
measurable objective performance measures might be available. For example: the number of
hours worked, number of units produced, timely delivery.
Criteria good performance measure:
! Risk. A good performance measure has little influence from other factors than the
agent’s action.
- Informativeness principle: any performance measure should be included in the
compensation formula that (with appropriate weighting) allows reducing the error
with which the agent’s performance is measured (minimizes variance) and by
excluding performance measures that increase the error with which effort is
measured.
- Relative performance evaluation: Performance is measured in comparison to other
people’s performance. Relative performance measures might decrease risk (variance
of performance measure) and therefore be preferred when there are factors outside the
control of the individual manager that affect the peer group performance considerably
(oil prices, interest rates, demand).
! Alignment. A good performance measure should be aligned with the company’s
objectives. Action directed at increasing the PM should also increase the company’s
objective. If increasing the PM can be achieved (more easily for the agent) without
increasing the company’s objective, the measure is not aligned with the company’s
objective. Then it is a distorted PM. This phenomenon is known as “The folly of
Rewarding A, while Hoping for B”.
It might be difficult or very costly to find a P (performance) that gives an incentive to
increase P (performance) and Y (output) simultaneously. Exception to the rule is
proven by Lazear (2000) in his windshield installers article where piece rates lead to
higher productivity. However, not all jobs can be narrowly defined and easily and
objectively monitored.
Reward based on quantity may lead to bad quality products, rewards based on relative
performance evaluation may lead to sabotage and reward based on individual
performance evaluation may lead to little cooperation. Distorted measures affect
peoples’ behavior unintentionally “you get what you pay for”.
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller xMarliah. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $3.17. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
48298 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 15 years now