Management and Markets

1
Management and Markets

• Incentives and Relational Contracting
• (usual thanks to George Baker)

2
Course Content (Strategy and Org Econ.)

• Overview Introduction to Strategy
• Market Competition (sessions 2-6)
• Theory of the Firm (sessions 7-8)
• Internal Organization Incentives and
  Performance Management (sessions 9-11)
• Summary and Application to Innovation

3
Trust and subjectivity

• Why do firms use subjective evaluations?
• Firms goals are not contractible
• Objective measures are problematic
• Distorted
• Uncontrollable
• What is required to use subjective assessments?
• Bosses must promise to pay bonuses based on
  subjective assessments
• Employees have to trust bosses to honor their
  commitments to pay bonuses

4
Baker, Gibbons and Murphy 1994

• Explicit bonus plans distort incentives
• Remember this from earlier work by Baker
• Could base the bonus on a perfect, but
  non-contractible performance measure
• Firm promises to pay a bonus b if the performance
  measure is high, and 0 if it is low

5
Relational Incentive Contracts

• Following Bull 1987
• Output (non-contractible) y(a) prob y1aa
• Pay is sb(y)
• Utility must be greater than outside alternative
  w
• Effort a b/2 based on costa2
• Profit for the firm a - a2 w
• E.g., if w0, a- s a b
• Firm would like to set b1

6
Incentive Compatibility

• Will the firm choose to pay the bonus?
• Assume trigger strategy by the worker
• The worker initially trusts the firm, and
  continues to do so for as long as the firm does
  not renege
• If the firm reneges, the worker will never work
  for the firm again
• Example used to explore possibility of relational
  contracting equilibrium
• Analogous to earlier discussion of collusion

7
Incentive Compatibility (cont)

• What is the firms temptation to renege?
• b once
• What is the cost of reneging?
• V(b) every period from next period on
• IC constraint
• V(b)/r gt b

8
Repeated game equilibrium

• If there exists a b that satisfies the IC, then
  a relational contract is feasible
• Nash equilibrium of the repeated game
• Comparative statics
• As r declines, the likelihood of an equilibrium
  with a relational contract goes up
• As V(b) increases, relational contract
  equilibrium becomes more likely

9
Relational Contracting

• Allows agents to transact when actions or
  outcomes are not contractible
• Things cannot be verified ex post by a third
  party
• Things cannot be adequately specified ex ante
• Requires that parties trust each other
• An equilibrium of an infinitely repeated game

10
The interaction of explicit and relational
contracts

• Do firms with good explicit contracts use
  stronger or weaker subjective bonuses?
• Substitutes The existence of good explicit
  contracts reduces the surplus available from the
  subjective bonus system
• Good explicit contracts reduce punishment,
  thereby making reneging more attractive
• Complements Firms with good explicit bonus plans
  earn more surplus from their workers, and so it
  is easier to sustain a relational contract
  equilibrium

11
Some Questions

• Does the use of subjective evaluation to correct
  for the distortions of objective incentives
  create inconsistencies that undermine the entire
  system of incentives?
• Are subjective evaluations inherently opaque?
  Does the use of such evaluations risk loss of
  credibility with employees and the market?
• If subjective evaluation is closer to the
  spirit of rewarding for performance (and
  objective evaluation the letter of the law), in
  a setting where objective measures are distorted
  are subjective measures necessary?
• Can a system of objective measures with
  subjective weights perform better than a more
  clearly articulated objective evaluation system?
• Has our consideration of various instruments to
  motivate employees been too limited?

12
Kreps (1990) on Corporate Culture

• Kreps speculates about the intersection of
  economic incentives and trust producing a view
  on the nature of corporate culture
• Fairness, trust, culture
• Economic concepts?
• Why does trust matter?
• What is trust?
• The equilibrium of a repeated game?
• A reputation for fair dealing?
• A reputation for efficient dealing?

13
Elements of the story

• Unforeseen contingencies
• Incomplete contracts the need for adaptation
• An adjudication process
• Let the firm decide
• Reputation
• The way we adapt to unforeseen contingencies

14
Trust Game
Dont give trust
A
Honor trust
Give trust
B
Abuse trust
15
Repeated games and the folk theorem

• At low enough discount rates, there exists an
  equilibrium of the repeated game that will
  achieve first best outcomes
• If the shadow of the future looms large enough,
  people can be induced to take actions that
  maximize the size of the pie

16
Repeated games and trigger strategies
t
D-C
C (1/r) C gt D (1/r) P ??????? r
C-P
17
Reputation

• If B has a reputation as a trustworthy employer,
  A will work for her and trust her in the first
  round
• What about a sequence of different As?
• So long as reneging is observable to all possible
  As, then Bs reputation will continue to induce
  As to work for B

18
The firm as reputation carrier

• What if the Bs dont live forever?
• Overlapping generations
• A manager buys the firm, and runs it for one
  period
• Will he renege on the relational contract?

19
Is reneging observable?

• Green and Porter 1984
• Price wars
• Punishment for non-cheating
• The difficulty of building and maintaining
  relational contracts especially not black and
  white contracts
• The problems of changing relational contracts
• When the world changes, contracts become
  impossible to honor

20
What is a culture?

• Principle or rule
• How an organization should respond to various
  anticipated and unanticipated circumstances
• Widely applicable and simple
• Culture is partly the rule, and partly the way
  that the organization communicates the rule
• In hierarchy, hierarchical inferiors believe that
  application of the rule will make it worthwhile
  to undertake (superior desired) action
• Communication key so that all know the rules
  relevant to them and can observe use of rule
• It is the product of past behaviors

21
Lincoln Electric v. the Machine Shop

• Why does Lincoln Electrics incentive system
  work?
• Characterize the incentive system at Lincoln
  Electric in terms of the theories of incentives
  we have studied so far.
• What do you see as the greatest threats to the
  success of LEs incentive system?
• What differences do you see between LE and the
  machine shop that Roy describes?
• What is missing (or what is present)?
• How important are non-piecework elements of the
  management environment in LE and Roys machine
  shop?
• How consistent is LEs system to the principles
  of scientific management?

22
Lincoln v. Roy (2)

• The workers did not trust management not to
  change the piece rate at Roys machine shop
• If management had decided not to change the piece
  rate, it would have cost them something in the
  short run
• Would it have been worth it in the long run?
• Lincoln Electric trust in many places in the
  system
• No moving the carrot
• The large subjective bonus

23
Applications of relational contracting models

• Relational contracts are important in
• Subjective performance evaluation
• Authority
• Asset ownership and the theory of the firm (e.g.
  scope of the firm)
• Strategic alliances (e.g. future decision making)
• Role of managers?
• To build and maintain relational contracts with
  employees, suppliers, board members, etc.

24
Final Questions

• How can these contracts be used to motivate..? Do
  they introduce additional bad side effects?
• joint or team production?
• creative job workers?
• Is the tenure system efficient? How should
  university faculty be promoted?
• Next Session Focus on innovation in the
  context of the theory of the firm. Think about
  how the various approaches to innovation
  correspond to the theories of organization and
  incentives we have discussed in the class.