2 Incentive Conflicts and Contracts Flashcards
What are Owner‐manager conflicts?
- Large corporations usually delegate decision authority to top executives
- Different conflict of interests can arise:
- Effort choice
- Salaries, bonuses, and perquisites
- Risk taking behavior
- Time horizons
- Overinvestment (empire‐building)
How does signalling as a solution to adverse selection work?
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.
What are examples for asymmetric information?
- 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
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?
- 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.
What is residual loss?
Residual loss = loss in gains from trade that results from the divergence of interests within the principal‐agent relationship.
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.
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).
What are Precontractual information problems?
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
Discuss the incentive conflicts that are likely to arise between owners and managers of a restaurant.
What are examples of agency relationships within firms?
- shareholders – board of (outside) directors (oversee management)
- board – senior executives (operating decisions)
- senior executives – lower level employees (e.g., production tasks)
How does screening as a solution to adverse selection work?
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
What are examples of incentive conflicts between shareholders and managers?
- 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)
What are Postcontractual information problems?
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
What is Agency relationship (or principal‐agent problem) and what problems typically occur?
• 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
What are examples of agency relationships between firms?
- firm – supplier (production of intermediate good)
- firm – law firm (legal advice)
What kind of firm ownership are there?
- 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