Incentives and Organization and RegulationManagerial EconomicsJack Wu

Outline

•organizational architecture•moral hazard•ownership•vertical integration

Organizational Architecture

•distribution of ownership • incentive schemes•monitoring systems

Moral Hazard

•asymmetric information about action•conflict of interest

Moral Hazard in Employmentworker’s marginal cost

employer’s marginal benefit

worker’s marginal benefit

Quantity (units of effort)

Marg

. co

st/b

enefit

(cents

per

unit

)

efficient effort

Moral Hazard in Banking

•premium for deposit insurance is not experience-rated ▫riskier the investment, the greater the

expected benefit for the bank owners and the higher the expected loss for the Central Bank conflict of interest

•Central Bank cannot easily monitor actions of the bank

Resolving Moral Hazard

•incentive scheme▫conditional payment▫quota

•monitoring system▫incentives must be based on observables

Incentive vs Risk

Efficient scheme balances•benefits of more effort •costs of risk bearing

▫degree of risk▫risk aversion

Relative Performance

•employment -- promote the best worker

•sports -- gold, silver, bronze •examination – grade on a curve

Multiple Responsibilities

•strong incentive▫more effort on that dimension▫less effort on other dimensions

Non-Profit Organizations

•school’s objective ▫maximize profit▫maximize education of students

•other examples – hospital, museum•non-profit organization to tone down

profit incentive

Holdup

•Holdup = opportunistic behavior = action intended to exploit another party’s dependence

• unlike moral hazard, holdup can arise even if information is symmetric

Resolving Holdup

•avoid specific investments•write more detailed contracts•vertical integration (redistribute

ownership)

Complete Contract

• specifies actions and payments in every contingency

• degree to which a contract should be complete ▫ potential benefits and costs at stake▫ extent of possible contingencies

Ownership

Residual rights•control -- rights that have not been

contracted away•income -- remaining after payment of all

other claims

Vertical Integration

Combination of assets for two successive stages of production under a common ownership• upstream: away from final consumer

▫Dominion Resources acquired Consolidated Natural Gas, 1999

• downstream: closer to final consumer▫Phillips Petroleum acquired Tosco, 2001

Vertical Integration: Impact

Owner •gets rights to residual control and

residual income •reduces potential for holdup

Regulation

Regulation

•natural monopoly•potentially competitive market•asymmetric information•externalities•public goods

Natural Monopoly

Average cost minimized with single supplier• large scale/scope economies • relative to market demand

Marginal Cost Pricing Require

provider•set price

equal to marginal cost

•supply quantity demanded

demand

marginal cost

Average Cost Pricing Require

provider•set price

equal to average cost

•supply quantity demanded

demand

marginal cost

average cost

Rate of Return Regulation

•maximum rate of return on rate base•disallowed profit returned to users

Potentially Competitive Market

Economies of scale/scope are small relative to market demand • technology • market demand

Structural Regulation

Bar franchise holder from vertically related markets

▫prevent monopoly from extending market power

Moral Hazard in Medicinesupply

inflated demand

true demand

quantity (million hours a mth)

pri

ce (

$/h

our)

a

b

Resolving Information Asymmetry•mandatory disclosure •regulation of conduct•structural regulation

Emissionsmarginal cost to society

quantity (tons/year)

marg

. co

st/b

enefit

($/t

on)

35

8000

marginal benefit to society

Emissions Fee

user fee

quantity (tons/year)

marg

. co

st/b

enefit

($/t

on)

35

8000

marginal benefit to society

Accidentsmarginal cost to driver

quantity (units of care)

marg

. co

st/b

enefit

s

marginal benefit to society

Public Goods

•legal framework enables excludability▫copyright ▫patent

•trade-off▫incentive for knowledge creation▫economically efficient usage of information

Public Provision

For some public goods, practically difficult to enforce exclusion • national defense• clean air• fireworks

Congestible Facilities

•social marginal cost varies with usage•resolve through user fee = social

marginal cost▫time▫usage