UNIVERSITY OF ESSEXDepartment of Economics

EC 951 Economics of Organizational Management

David Reinstein Some key concepts

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Themes • Perspectives on organizations• Bounded rationality• Asymmetric information• Performance measures• Group incentives• Internal labour markets• CEO compensation• Internal structure of the firm• External boundaries of the firm

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Theme 1: Perspective on organizations

• Description of organizations – created entities within and through which

people interact to reach individual and collective goals

• Objective of organizations:– Satisfy wants or needs of individuals

• Evaluation of organizations:– evaluated in terms of performance, notably

efficiency

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• Some key elements:– Coordination– Transaction costs

• Coase theorem

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Theme 2: bounded rationality• Complete contracts

– Specifies actions for every thinkable contingency• Limits to complete contracts

– Transaction costs– Bounded rationality

• Incomplete contracts– Room for opportunistic behaviour

• Responses to opportunism:– Inflexible contracts– Implicit/relational contracts– Integration– Commitment– reputation

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Theme 3: asymmetric information• A key concepts: private information

– Incentive constraints• Adverse selection

• Nonrandom selection of people trading

• Consequences:– Rationing or closing markets

• Solutions to adverse selection:– Government intervention– Signalling (warranties…)– Screening (own risk…)

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• Moral hazard:– Unobservable actions

• Framework: principal-agent model– Conflicting objectives– Gains from cooperation– Principal cannot fully verify or monitor agent’s

actions

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• Contracts: – Observable effort

• No conflicts of interest• Compensate for disutility

– Unobservable effort• Fixed wage gives no incentives• Pay-for-performance• Trade-off between power of incentives and costs

– High-powered incentives lead to high efforts but costs are higher since agent must be compensated for risk (if agent is risk averse)

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Theme 4: performance measures

• Some basic principles of incentives:– Incentive-intensity principle

• Optimal intensity incentives depends on:– Incremental profits: P’(e)– Precision performance evaluation: var(x) – Risk aversion: r– Responsiveness to incentives: c’’(e)

– Informativeness principle• In an optimal contract, all information should be

used. That is, pay should be contingent on every relevant indicator.

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– Equal compensation principle• For all activities that cannot be monitored, marginal

rate or return to time spent to each activity must be equal

• if there is an activity for which performance cannot be measured, incentive pay cannot be used for any other activity

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• Ratchet effect– Tendency for standards to increase over time– Can be fixed by rotating jobs, reputation …

• Relative performance measure• Subjective performance

– Commitment problem• reputation

– Reluctance by managers to differentiate between workers• Forced distribution

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Theme 5: group incentives• Contracts for groups

– Profit sharing– Gain sharing

• Advantages include– Easier to determine– Sharing risk among members– Group has information– Cooperation encouraged?

• Disadvantages include– Group conflicts– Free riding

• Worse for larger groups

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Theme 6: internal labour markets• How to penalize worker if you cannot fine

him/her?• Termination of relationship• Efficiency wages

– Wage above market-clearing wage to prevent shirking• Why internal labour markets?

– Rigid instrument• Reasons include:

– Efficiency wages– Firm specific capital– Assessing performance

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• Why steep upward sloping age-wage profile?– Selection workers who stay– Prevents shirking

• Promotions– Assign people to jobs– Give incentives to work

• Problems– Delay promotions– Peter principle

• Tournaments– Less information needed– Commitment for firm– Too few/many incentives?

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• Why tenure?– Commitment– Prevent seniors selecting least qualified

juniors• Why up-or-out rules?

– To prevent delay promotions– Careful evaluations

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Theme 7: CEO compensation• CEO compensation special in at least two respects

– High level– High powered (?)

• Can be explained by principles of incentives• Are they taking enough risks?

– Human capital at stake (reputation concerns)

• How to promote risk-taking?– Give insurance (stock options, consensus system…)

• Are incentives strong enough?• DR: Tradeoffs between incentive to perform and risk-

taking

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Theme 8: internal structure

• What is the optimal design of an organization?

• Key aspects: – information flows– Coordination– Authority– decentralization

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• Common forms:– Unitary form or U-form– Multidivisional form or M-form– Matrix

• U-form:– Functional economies of scale– Coordination between product lines and

geographic area – Congestion at the top– Poor quality of information

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• M-form:– Efficient cross-functional coordination within product lines– Good quality of information– Weak coordination across product lines

• Matrix: – Strong coordination across products and across functions– Preserves some of the information efficiency of the m-form– Very (too?) Complex to implement – Agents are overwhelmed by the cross-flow of information– Lack of clarity in authority lines

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• Some basic trade-offs:– How to assign authority?

• Production costs– Using local information versus economies of scale

• Incentives and control– Using local information versus moral hazard problems

– Product versus functional organisation:• The product organisation relies on simpler

contracts but imposes restrictions on the combinations of effort levels that can be implemented

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Theme 9: boundaries of the firm

• Part 1: internal boundaries

• Transfer prices– Not only redistribution– Double marginalization problem if there is no

outside competitive market• Multidivisional firm

– Distortive transfer prices versus performance measure

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• Part 2: external boundaries

• Integrate vertically or not?– Advantages market procurement

• economies of scale• Economies of scope• Core competencies• Independent (no favoritism problems)• Competitive (sometimes through competitive

bidding)

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– Some advantages vertical integration• Improved coordination• Protection investments• Monitoring more easy• Less dependent• Barrier against entry by competitors• No monopoly distortions • Price discrimination

• Alternative vertical relations– Co-op– Franchise– Supplier organization

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• Expand horizontally or not?– Some Advantages of horizontal expansion

• Exploiting economies of scope• Creating monopoly power

– Merger paradox– bundling

– Some Disadvantages of horizontal expansion:• Coordination problems• Conflicting cultures

• Some Alternatives:• Business alliances• Keiretsu