Examples Flashcards
You own a company and you want to set up a new CRM System. However, you lack the expertise in introducing the new software and you consider hiring a consultant. The system lets you manage your customer relations much more effectively and the company could increase its profits.
However, there is also a risk: If the consultant does a bad job, your sales will only increase moderately and the cost for the consultant will outweigh the benefit.
You wonder how you should structure the contract with the consultant to insure
that the project will be a success.
Moral Hazard
Non-contractible effort, contingent contract
Suppose that you are a police officer for the past ten years. The government is considering two different policies for wage increases. ▪ In one policy, police officers would receive a 4% raise every year. ▪ The other policy would allow police unions to make a request, and the government would either accept this request or give a lower wage.
Which policy would you recommend?
Behavioral Extensions
You want to hire a manager for your company. You know that the profits of the company depend both on the general market condition and the managers effort in running the company.
Specifically, a hard-working manager can be unlucky and the company might make a loss because of adverse market conditions. Similarly, a lazy manager can be lucky and make and the company could be highly profitable because the economy is booming.
You wonder what would be the best contract
Moral Hazard
Stochastic Signal
Sell the shop vs. Step function
You are a manager in a corporation and you need to hire a new employee. You want to hire a high ability person.
However, suppose that candidates cannot accurately signal their quality to you, so that all applicants look essentially the same to you at the time of hiring.
What can you do to hire a high ability person?
Asymmetric Information
Screening
Offer a menu of contracts
You run a large sales organization and want to make sure the sales representatives work hard.
All of your managers agree that the contract should be a contingent contract. However there is also disagreement: Some managers argue to make the contract contingent on sales because effort is unobservable Other managers argue that the company should invest in monitoring technology to make effort observable and to make the contract contingent on effort.
What are the arguments on each side?
Input vs. Output Monitoring: Noisiness of Signal / Risk
Output monitoring is more prone to error: external factors may affect the output
Input monitoring is more accurate: easy to see how many hours someone was in the office, but harder to see if they were “working hard”
You are the CEO of Apple and think about offering a cell-phone insurance to insure your customers against damage to iPhones.
One of your managers has been in a contract design class at ETH Zurich and tells you that Apple is in a better position to bear the risk than its customers because it is one of the wealthiest companies in the world.
Moreover, the risk is well-diversified because the risk of one person damaging his phone is uncorrelated with another person damaging her phone.
What do you respond?
Risk-sharing
Who controls the risk should bear it.
Risk should be borne by the person better suited bear it
Customer is not diversified, but customer controls risk
You are the owner of a truck company and wonder how to incentivize your drivers? One of your managers says that you should always reward the drivers who deliver the goods faster (given they arrive intact). He says that an optimal contract always rewards better outcomes?
Is he right?
Output contains information
Likelihood ratio
The principal wants to reward hard work
So any outcome that makes the principal revise beliefs upwards will be rewarded
The optimal incentive scheme is not necessarily increasing in output
You are a wealthy property owner with many residential buildings in major cities around the world which you rent out to tenants.
You wonder whether you should assign the risk of damage to your buildings due to floods and earthquakes to your tenants?
Should you do this?
Risk-sharing
Diversification
You hire an investment manager and think that a 20% loss on a blue chip investment fund shows that he certainly has misbehaved.
You decide to have aggressive claw back provisions if performance is in this range?
Should the investment manager accept this contract? Pros/ and Cons?
Case for linear incentives: Robustness to error
we don’t know the risk of the stock market perfectly
If there is error, these “fine-tuned” incentive schemes can be very costly.
Suppose that you and a business partner are choosing how to interact with one another. You can both choose to cooperate or to defect. There are no explicit contracts.
▪ If you both cooperate, you will each make large profits. ▪ If your competitor cooperates and you defect, you will make an even larger profit, while your competitor’s profit will vanish.
▪ If you both defect, you will both lose money.
What do you do?
Relational Contracting
Prisoners’ Dilemma - One Shot
Repeated Prisoners’ Dilemma
You design the contract for a bridge. You know construction takes 5 years. In the final phase of the contract the cable and damper technology is installed.
You want the engineering company to make every effort to give it their best in developing this technology as you want vibration on the bridge to be low (otherwise users might feel unsafe).
You consider putting in a clause that gives the company only a small base salary for mediocre performance and an enormous bonus for achievement above a certain
threshold.
Action Space Decisions are made over time Effort is not chosen only once Actions available change over time Information changes over time The step function can lead to path dependence Linear incentives do not
You run a big computer games company. In order to market your product to “hard core gamers” you need to rely on small distribution partners who have street credibility with the hard core gamer community.
You decide to compensate the distribution partner by giving them a commission per copy sold.
You have a lot of bargaining power and can drive down commission fees to very low levels.
Is this a good idea?
Incentive-Rent Extraction Tradeoff
Low commission: more profits per sale, but fewer sales.
High commission: lower profits per sale, but more sales
Alternative: Have the distributor pay an up-front fee to the producer combined with high commission. Similar to the “sell the shop” contract.
Imagine you are an inventor and you decide whether you want to disclose an idea to a VC or whether you want to go it alone.
If you go it alone you know you will only have moderate success.
If you disclose the idea to the VC, the VC can either cooperate with you and provide you with capital and advise which make the project highly profitable for both you and the VC.
But he can also steal the idea from you by cheating you out of your profits. This can either just be a disappointment or cause severe damage do you (you might go into
personal bankruptcy).
Legal Regime Supplement
Liquidated Damages
Imagine you own a software company and you have two types of customers: Frequent users for whom the software is essential to run their business. And infrequent users who find the software useful but whose business model does not depend on it to the same extent.
You want to charge the frequent users more than the infrequent users. What is the
problem?
Asymmetric Information
good after sales service is appreciated by both types of customers, but essential for the frequent
users while only “nice to have” for the infrequent users
“screen” the two types of clients. Company might offer a menu of contracts:
One with a high price and good after sales service.
Another one with a low price and no after sales service
Suppose you are producer of a high quality product in a market that is full of really bad products which are a lot cheaper.
Customers don’t know the difference between your product and the cheap products.
What might you do?
Asymmetric Information Signaling Offer a generous warranty Expensive to offer this. But it is even more expensive for a low-quality producer Invest in your brand
